Suppose you plan to take a 401(k) loan; you must be sure that you are qualified to borrow from your plan. You can check your eligibility by reading through your summary plan description or checking with your 401(k) plan’s administrator. Most employers allow you to borrow money when you want to buy a car, furnish your house, and other purposes. Still, some employers give room for 401(k) loans only when facing financial challenges.
Taking a 401(k) loan is easy because the process requires a little paperwork and no credit check. The loan also charges a small fee as the processing fee.
How much 401(k) loan can you take?
You can not borrow the entire amount in your 401(k) plan irrespective of the total amount in your 401(k) account. As a general rule, you can’t borrow more than half of your vested plan benefits or $50,000, whichever is less. However, if your 401(k) account value is below $20,000, you can borrow about $10,000, even if this is your total balance.
Requirements for paying back 401(k) loan
Ideally, you should repay the loan within five years by making regular payments. This payment is usually through payroll deduction. Suppose you use the money to buy a house; you may repay the loan for more than five years.
You must adhere to your loan repayment requirement because if you don’t pay the loan back as required, it will be treated as a taxable distribution. You will pay income tax on your existing loan balance and 10 percent federal penalty tax if you are below 59½. If you have any after-tax or Roth contributions in your 401(k) plan, you will not pay the usual income tax on them.
Advantages of taking 401(k) loan
The following are the benefits of borrowing from your 401(k) plan:
- As long as you pay the money back on time, you will not pay penalties or taxes on the loan.
- The interest rates on TSP loans will be consistent with the bank and other commercial institutions’ rates for such loans.
Disadvantages of taking a 401(k) loan
Despite the advantages of taking this loan, there are pitfalls in borrowing from your 401(k) plan.
- Suppose you don’t repay the loan on time? It will be considered as a taxable distribution.
- Suppose you leave your job, and you have an existing loan balance? You must repay the entire loan within 60 days. Suppose you don’t pay back within 60 days? In that case, it will be considered as a taxable distribution, and you will pay the accompanying regular income taxes and penalty tax if you are below 59½.
- Most of the time, the loan is deducted from your 401(k) plan account, and your bank is credited with the loan payment. Therefore, you will lose those tax-deferred investment earnings that may have accrued on the loan had they been in your plan account.
- You must pay back the loan with after-tax dollars.
You can take a hardship withdrawal from your 401(k) plan if you can show that you have immediate and urgent financial needs and don’t have any other means to fulfill your needs. It now depends on your employer to examine if your financial needs qualify for a hardship withdrawal or not.
The majority of employers allow hardship withdrawals if you need to pay you and your relative’s healthcare expenses, burial or funeral expenses of your relative, related tuition and educational expenses, and your principal residence costs.
Your employer may allow you to withdraw funds if you need to pay due taxes and penalties on the hardship withdrawal. Generally, your employer will ask you to submit a written request for a hardship withdrawal.
How much 401(k) withdrawal can you make?
Generally, the maximum amount you can withdraw is equal to your entire 401(k) contribution, minus the existing hardship withdrawals you have made. Sometimes, you may be able to withdraw your contribution earnings. Consult your plan administrator to know the rules applicable to your plan withdrawals.
Advantages of hardship withdrawal
Taking a hardship withdrawal is your best option if you are in urgent need of money and don’t have any assets to rely on, and your plan doesn’t permit you to take a loan since you don’t have a means of repayment.
Disadvantages of hardship withdrawal
Hardship withdrawals will lower your retirement savings because these withdrawals are subject to income taxes. Also, your retirement nest egg will reduce because your growing funds are no longer tax-deferred. The major disadvantage of making this withdrawal is that you may not contribute to your plan six months after taking a hardship distribution.
Suppose you qualify for an employer 401(k) contribution match; you may be able to withdraw these dollars as soon as you become vested. Special rules may apply to you if you begin your active duty after September 11, 2001, and you are a reservist.