Tax Question of the Week: How Do I Borrow from my 401(k) Retirement Account?June 17, 2014
Although fast cash from a 401(k) loan may be an easy answer, there are many risks you should be aware of.
It is easy to find yourself short on cash, needing finances for emergencies, medical problems, and even travel or business opportunities. Taking a loan from your 401(k) plan gives the impression that this problem will diminish easily. However, careful consideration of all the necessary steps involved in taking out such a loan, as well as the inevitable results that follow is crucial to understand.
Applying for a 401(k) loan:
- After you have considered all of your other options, investigate a 401(k) loan. Such a loan can be a beneficial option for someone who expects a large flow of money soon, but needs cash immediately. Such a loan may be useful for education or business capital reasons. Make sure that you carefully consider your repayment plan. Realize that a hasty decision for a loan could jeopardize your future finances. Easy money is never easy!
- Check your 401(k) plan or verify with your company that your plan permits loans. If it does, realize that loans are limited to amounts less than $50,000 or 50% of your vested balance.
- Complete a 401(k) request form, or call the 401(k) administrator and request your loan through a phone call. Be prepared to provide your social security number, account information, the amount you need to withdraw, and the manner in which you would like to be paid. Once you evaluate your ability to take out a loan, fortunately, neither income level nor credit score is considered.
- Be prepared to pay interest on your loan. Fortunately, interest rates on 401(k) loans are usually low, and you will be paying that interest to your own account directly as opposed to a bank. The interest payments negatively impact the financial performance of your 401(k). You need to balance your need for cash in the short-term with your long-term retirement planning goals.
- Realize that most loans need to be fully repaid within five years with at least quarterly loan payments. If you neglect to pay back the loan according to its terms, you will have to cope with severe tax consequences.
- The IRS considers you to have received a taxable distribution equal to the unpaid balance if payments are not made which prompts a federal income tax liability, perhaps a state income tax bill, and for borrowers under age 59 1/2, a 10% penalty tax.
- If you are terminated or leave your company, your entire loan is typically due within 30-90 days.
- If the loan goes unpaid, your account balance may be permanently lessened. The strict tax law imposes limits on how much you can contribute to an account each year so do not assume that you can make bigger contributions later on to make up amounts.
Your loan will be accessible quickly and you can borrow for virtually any reason, but consider all of your options before you decide to bind yourself to the obvious risks involved in the process.
Your nest-egg damage will be multiplied if your employer prohibits contributions to your 401(k) while you have an outstanding loan. First, you’ll lose out on what the pretax contributions additional compounded growth potential would have been. Second, your current taxable income will increase. And if your employer matches contributions, you’ll lose out on that too.
Don’t let ease of borrowing mislead you into thinking this is an easy decision. Consider a 401(k) loan only when you need the money immediately and there are no better alternatives. Why? Because a 401(k) loan isn’t without risk. If you’d like to learn more about the possibility and associated risk of talking a withdrawal from your 401(k), please contact us.
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