Section III-A - Lesson 8
Your 401k - Taking Withdrawals or Loans
Your 401k is not designed to be a very user-friendly place to go when you need to remove some money. However, there are three basic situations under which you might need to remove money, and you need to know just how to do this, as well as how not to do this.
At the very least, you’ll want to roll your money out of your 401k and into an IRA once you retire, and we’ll cover this procedure in great detail in a separate lesson later in this section. You may also want to take your 401k with you when you move to a new job, and we’ll cover this procedure in a separate lesson as well.
The situation we’ll address right now is the one where you need to take some money out simply because you need it and because you have no other place to get it. Hopefully this won’t happen to you, because you’ll have a regular money account to tap for these kinds of non-retirement needs, but who knows? It’s nice to know you can get some money if you have to.
A word of caution is in order here. Not all 401k plans have the same ground rules. About nine out of ten plans permit “hardship withdrawals” and most, but not all, permit 401k loans, but with varying provisions. So nothing that we’re about to say can be taken as gospel. Check out the regulations of your own company’s plan before arriving at any decisions.
Basically, if you need money, you do not want to get it on a so-called hardship withdrawal. You want to get it on a loan. There are so many disadvantages to a hardship withdrawal that this truly should be used only as a last resort.
Hardship withdrawals are granted only for “immediate and heavy” financial needs, including the payment of college tuition, purchase of your primary residence, payment of medical expense, and to prevent foreclosure on your primary residence. If you avail yourself of this option you’ll pay full taxes on the withdrawal, plus a 10% penalty, and will usually be suspended from making further contributions to the plan for a full year.
If, instead, you're allowed to borrow money on your 401k, your situation would be much improved. You’d still be better off finding money in a regular money account, but taking a loan is a much more intelligent solution than taking a hardship withdrawal.
Typically you can borrow up to 50% of the vested balance in your 401k account to a maximum of $50,000, and you have up to 5 years to pay it back. You can borrow for any purpose you want, not just the four reasons listed above for a hardship withdrawal, and you don’t have to pay taxes or penalty on the money you receive because it’s a loan and not a distribution. Neither are you suspended in any way from continuing to contribute to the plan, which you should do, even as you pay back the loan.
The interest rate on this kind of loan is usually very reasonable because, after all, you’re borrowing your own money. The interest you pay, along with the principal, goes right back into your own 401k account, and the payment is set up as a payroll deduction that comes out of every check, along with your continuing 401k contribution.
There are still disadvantages to tapping your 401k this way, and reasons why you should have a regular money account instead. There is an “opportunity cost” to making this kind of a loan. Let’s say you borrow $12,000 from yourself to help pay for your daughter’s wedding, and you pay it back over the next five years. That full $12,000 does not participate in the growth of the market for the next 5 years. If the market doubles, for example, that $12,000 does not become $24,000 and you lose that opportunity.
As you pay back your loan, however, you’ll be “earning” the interest that you’re paying yourself, but this is coming out of one pocket and going into the other. Sooner or later, all of this money will be back into your account and you’ll be back to full participation. What you do not want to do is reduce your usual contribution, in any way, while you pay back the loan. You want to continue your usual deduction plus a deduction to pay back your loan.
A bigger potential disadvantage of having this loan would occur if you were laid off or terminated or changed jobs while this loan was still in existence. The balance of the loan becomes due and owing when you leave. The amount outstanding is deducted from your 401k balance and reported to the IRS as if it was a distribution and subject to the usual tax and penalties.
You could avoid this “distribution” at termination if you had another way to pay the balance on the loan. If you were able to borrow money elsewhere, you could effectively “move the loan” from your 401k to a bank, for example, and avoid the distribution.
Of course, if you’re able to borrow money elsewhere, you probably should have done this in the first place, instead of borrowing on your 401k. The big benefits of your 401k are the tax advantages and you want to keep as much of your money as possible working and compounding on this tax-advantaged basis.
Assuming that a 401k loan is nonetheless your only option, it’s usually fairly easy to arrange. You fill out an application and usually pay an origination fee of about $100 to cover the cost of processing the paperwork. Most plans limit you to having only one or two loans outstanding at any given time, so be sure to borrow enough to meet your needs. How quickly you can get your money varies widely from one plan to another.
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