Other Alternatives To A 401 Loan
Borrowing from yourself may be a simple option, but its probably not your only option. Here are a few other places to find money.
Use your savings. Your emergency cash or other savings can be crucial right now and why you have emergency savings in the first place. Always try to find the best rate on an online savings account so that youre earning the highest amount on your funds.
Take out a personal loan. Personal loan terms could be easier for you to repay without having to jeopardize your retirement funds. Depending on your lender, you can get your money within a day or so. 401 loans might not be as immediate.
Try a HELOC. A home equity line of credit, or HELOC, is a good option if you own your home and have enough equity to borrow against. You can take out what you need, when you need it, up to the limit youre approved for. As revolving credit, its similar to a credit card and the cash is there when you need it.
Get a home equity loan. This type of loan can usually get you a lower interest rate, but keep in mind that your home is used as collateral. This is an installment loan, not revolving credit like a HELOC, so its good if you know exactly how much you need and what it will be used for. While easier to get, make sure you can pay this loan back or risk going into default on your home.
Loans To Purchase A Home
Regulations require 401 plan loans to be repaid on an amortizing basis over not more than five years unless the loan is used to purchase a primary residence. Longer payback periods are allowed for these particular loans. The IRS doesn’t specify how long, though, so it’s something to work out with your plan administrator. And ask whether you get an extra year because of the CARES bill.
Also, remember that CARES extended the amount participants can borrow from their plans to $100,000. Previously, the maximum amount that participants may borrow from their plan is 50% of the vested account balance or $50,000, whichever is less. If the vested account balance is less than $10,000, you can still borrow up to $10,000.
Borrowing from a 401 to completely finance a residential purchase may not be as attractive as taking out a mortgage loan. Plan loans do not offer tax deductions for interest payments, as do most types of mortgages. And, while withdrawing and repaying within five years is fine in the usual scheme of 401 things, the impact on your retirement progress for a loan that has to be paid back over many years can be significant.
If you do need a sizable sum to purchase a house and want to use 401 funds, you might consider a hardship withdrawal instead of, or in addition to, the loan. But you will owe income tax on the withdrawal and, if the amount is more than $10,000, a 10% penalty as well.
How Do I Repay My 401k Loan
If you have a 401 loan, you are required to make timely loan payments to your 401 account. Here is how to repay your 401 loan on time.
If your employer allows 401 loans, you can tap into your accumulated savings to borrow up to $50,000. As long as you have a sufficient balance, you can be allowed to borrow from your 401 and pay back the loan over time. While most employers require automatic loan payments through payroll deductions, some plans may rest this responsibility on employees, and you have to figure out how to pay the loan on time.
Most 401 plans require employees to make automatic loan payments from their paycheck through payroll deductions. If you opt out of automatic loan payments, you should create a structured plan on how you are going to pay the loan. You can also make extra payments or a lump sum payment to pay the 401 loan early. If you have an unpaid loan in the former employerâs plan, you can take a new 401 loan with the new employer to pay the old 401 loan.
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When You Have A Comfortable Retirement Cushion
If youve been saving steadily over the years and choosing solid investments, you may be ahead of schedule when it comes to meeting your retirement goal. If thats the case, and your job is stable, taking a loan from your 401 may not be too detrimental to your retirement outlook. You could use the money for the purchase of a vacation home, for exampleor, if you have a child in college, as a less expensive alternative to student loans.
Alternatives To Taking Out A 401 Loan
If youre unsure about using a 401 loan, think about other ways to get money for the time being.
- Stopping 401 contributions. Instead of continuing to stash that money away, pause contributions so you can pocket more of your cash right now.
- Take a hardship distribution from your 401. The CARES Act waives the 10% penalty for hardship distributions, which means if you are younger than 59 ½, you can take money out of your retirement without facing the extra tax charge.
- Take out a different type of loan. A personal loan doesnt borrow from your future self and doesnt require any collateral. A home equity loan or line of credit might get you a lower interest rate and longer repayment terms, but youd be borrowing against your home, like a second mortgage. Even so, this might be an easier or less-expensive way to borrow money quickly.
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Low Or No Application Fees
A 401 loan isnt a true loan, so any application fees are usually minimal. If your plan does have an origination fee, this usually goes to the plan administrator, however, not back into your account.
Many plans charge an origination fee of up to $75 per loan, so you could lose 7.5% if you borrow $1,000.
Be Careful Using 401 For A Down Payment
The biggest challenge most buyers face when purchasing a home? Coming up with that big down payment. Even if your mortgage lender only requires a down payment of 5 percent, that still comes out to $10,000 for a modestly priced home of $200,000. Many buyers simply don’t have that much cash lying around.
If you have a 401 plan at work, though, you might have a convenient source for down payment funds. You are allowed to borrow money from this retirement account for a down payment. You just have to pay back your loan — with interest — on time to avoid any penalties or taxes.
But does doing this make financial sense? That depends upon how badly you want the home, how close you are to retirement and how certain you are that you can pay back the loan on time.
Heather McRae, senior loan officer with Chicago Financial Services in Chicago, said that a 401 loan has helped several of her clients gather the funds they need for down payments. She considers it a smart financial move for borrowers who know they can handle the payback schedule.
“If you don’t have the money for a down payment and you don’t have family members who are kind enough to gift you the down payment, you’re kind of out of luck,” McRae said. “The 401 loan is often the best option for these buyers. If you haven’t saved the money for a down payment and you’ve fallen in love with a property, the 401 can make the purchase work.”
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Late Repayment Is Potentially Costly
When you take a 401 loan, you pay no taxes on the amount received. However, if you don’t repay the loan on time, taxes and penalties may be due. Specifically, if the loan is not repaid according to the specific repayment terms, then any remaining outstanding loan balance can be considered a distribution. In that case, it becomes taxable income to you, and if you are not yet 59 1/2 years old, a 10% early withdrawal penalty tax will also apply.
If you leave employment while you have an outstanding 401 loan, your remaining loan balance is considered a distribution at that time, unless you repay it. However, you can avoid taking the tax hit by rolling over the outstanding balance into an IRA or another eligible retirement plan by the due date for filing your federal income tax return for the year in which the loan was characterized as a distribution.
What Are The Differences In The Loan Rules For Amounts Borrowed By Participants After Hurricanes Harvey Irma And Maria
For participants affected by Hurricanes Harvey, Irma, or Maria, the maximum amount that can be borrowed from August 23, 2017 , September 4, 2017 , or September 16, 2017 , through December 31, 2018, from a plan is generally increased to the lesser of $100,000 or 100% of the participants account balance. In addition, repayments due from affected individuals may be suspended by the plan for one year.
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Is A 401k Loan Taxed Twice
Another myth is that when you borrow from your 401k, you are being taxed twice because youre paying the loan back with after-tax money.
But in truth, only the interest part of the repayment is treated that way. And being twice taxed on interest from this kind of loan is likely to cost less than what it would cost to borrow money in another way.
If You Default On Your 401 Loan You’ll Owe A Penalty
If you do not pay your 401 loan back as required, the defaulted loan is considered a withdrawal or distribution and thus is subject to a 10% penalty applicable to early withdrawals made before age 59 1/2. That’s potentially a huge cost, especially when you also consider the loss of the potential gains your money would have made had you left it invested.
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Other Down Payment Funding Options
Taking money from your 401 either in loan or withdrawal form is not the only way to come up with money that you can use for a down payment on a house. Here are some other options that are available:
- FHA Loans
If you’re a first-time homebuyer, you can get an FHA loan to finance your home purchase. With an FHA loan, you will not have to put down 1020%. Instead, you can put a minimum of 3.5% down as long as your credit score is above 580.
- Gift From Friends or Family
If you have a generous friend or family member who is willing to help you out with a down payment, then this is a good option. Most lenders will allow gifts to be used for a down payment. However, the amount of gift money that can be used for the down payment may vary depending on the type of loan and the lender. Be sure to ask your lender what their policies are before you try to use a gift as a down payment.
One party that you are not allowed to get a gift from for a down payment is the seller. As Sullivan at HUD explains, “We have long prohibited that the sources of payment be the seller. It is critically important that there be separation between buyer and seller in the transaction. There was a time, for a while, when the FHA would insure mortgages where the buyer of the home was contributing a down payment that was financed by the seller. We found those loans to be incredibly risky and defaulted at a much greater rate. And so, we prohibited that practice.”
- IRA Withdrawals
- Assistance Programs
- Sell Assets
Possible Consequences If You Borrow From Your 401
Although paying yourself interest on money you borrow from yourself sounds like a win-win, there are risks associated with borrowing from your retirement savings that may make you want to think twice about taking a 401 loan.
- The money you pull out of your account will not be invested until you pay it back. If the investment gains in your 401 account are greater than the interest paid to your account, you will be missing out on that investment growth.
- If you are taking a loan to pay off other debt or because you are having a hard time meeting your living expenses, you may not have the means to both repay the loan and continue saving for retirement.
- If you leave your job whether voluntarily or otherwise, you may be required to repay any outstanding loan, generally within 60 days.
- If you cannot repay a 401 loan or otherwise break the rules of the loan terms, in addition to reducing your retirement savings, the loan will be treated as taxable income in the year you are unable to pay. You will also be subject to a 10% early distribution tax on the taxable income if you are younger than age 59½. For example, if you leave your employer at age 35 and cannot pay your outstanding loan balance of $10,000, you will have to include $10,000 in your taxable income for the year and pay a $1,000 early distribution tax.
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How Much Can Be Borrowed From A 401 Loan
It depends on how much you have in your account. You can borrow up to 50% of your vested account balance, but you cant borrow more than $50,000. Even if you have a balance of $200,000, the IRS wont let you touch more than $50,000 of it.
The only time you can borrow more than 50% is when you have a balance of less than $20,000. In that case, you can borrow up to $10,000, even if you only have $10,000 stashed away.
The Drawbacks Of Taking Out A 401 Loan
On a normal day in a normal market, borrowing from your future self wouldnt be a good idea. Heres why:
- You never get that money back. Even when you repay your loan, the money that wouldve been there the entire time doesnt get a chance to earn and grow. Youre losing out on earnings by taking money out early.
- You might need to pay it off sooner. If you leave your job , youll need to repay your loan by the upcoming tax deadline. So if you took out a 401 loan right now and lost your job next month, youd be on the hook for paying it by the .
- Repayment is with after-tax dollars. That means when you withdraw the money again later down the road, itll be taxed again.
- You could get taxed anyway. If something comes up and you cant pay your loan back, its considered an early distribution and youll face the 10% penalty.
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Caveats To Borrowing From Your 401
Some 401 plans allow a withdrawal in the form of a loan, but some do not. You must check with your 401 plan administrator or investment company to find out whether your plan allows you to borrow against your account balance. You can usually find their contact information on your statement.
Some companies allow for multiple loans.
How Much Tax Do I Pay On 401k Withdrawal
When you withdraw funds from your 401 account, you will owe income taxes and a potential penalty. Find out how much you will owe.
One of the attractive features of a 401 plan is that it is tax-deferred, meaning that there is no tax charged on contributions, or on interest and gains earned on the retirement savings until you withdraw it. This allows individuals to contribute a bigger portion of their paycheck to their retirement savings up to the 401 contribution limit. However, you will still have to pay taxes when you withdraw money from a 401 plan.
When you make a withdrawal from a 401 account, the amount of tax you pay depends on your tax bracket in the year when the withdrawal is made. For example, if you fall in the 12% tax bracket rate, you can expect to pay up to 22% in taxes, including a 10% early withdrawal penalty if you are below 59 ½. However, if you are above 59 ½, you will only pay income taxes on the amount withdrawn. You must file your annual tax return, reporting all the income earned during the year, including the 401 distributions, and taxes you have already paid.
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Bad Reasons To Borrow Against A 401k
If youre borrowing money for ordinary expenses that should be part of your budget like mortgage or rent payments you have a spending problem. These are not unexpected expenses they are what it costs to live your life. You either need to spend less money or make more, ideally both.
Your 401k is also not an emergency fund. You should have at least $1000 in an emergency fund and ultimately six months worth of expenses. That is the money you use for an unexpected expense like a significant car or home repair.
Your 401k is not a source of discretionary spending. Do not pay for things like a vacation or a house full of new furniture. Those are things you have to save up for. Your 401k isnt savings its retirementsavings.