Borrowing from 401(k) Retirement Savings: What You Need to Know
Even the best planners face unexpected financial challenges. As your financial picture changes, you may be tempted to dip into your 401(k) to cover these needs. There are definite pros and cons to borrowing from your retirement plan. Here, we’ll cover the answers to the most commonly asked questions about 401(k) loans and how borrowing from your retirement savings works.
What is a 401(k)?
A 401(k) plan is an employer-sponsored retirement account designed to help you save money for your future. These plans allow you to contribute pre- or post-tax dollars, and grow over time from your automatic payroll deductions, interest accrued from investments, and if you’re lucky, an employer match. For employees of public education institutions and certain non-profits, you may have a 403(b) plan.
What are the most common reasons to borrow from your 401(k)?
Typical reasons you may consider dipping into your 401(k) include:
- Paying off debts e.g. credit card debt, medical bills, college loans, business, etc.
- Down payment on a home
- Unplanned repairs to your home or car
- Small business shortfalls due to an emergency such as COVID-19
- Medical emergencies
There are a few different ways an individual may be able to borrow against their retirement savings: a hardship distribution, wherein the money is taxed to the individual and is not paid back to the borrower’s account, a loan plan, which must meet specific requirements, and an early withdrawal. However, not all 401(k) plans allow for loans that are not hardship distributions. Before you use your 401(k) to fund emergency expenses, you’ll want to weigh the pros and cons. Just because you can borrow against your 401(k) doesn’t mean you should.
What are the advantages to borrowing from your 401(k) plan?
Some of the benefits of borrowing from yourself include:
- No credit check required. There is no credit check required to borrow from your retirement savings, and no impact on your rating unless you fail to pay the amount back on time.
- Principal and interest go back into your pocket. Since you’re borrowing from yourself, you won’t lose out on the interest that would normally go to a lending institution.
- Short-term need for fast cash. Investopedia defines a “serious liquidity need” as a one-time major crisis that can’t be met by your regular income flow. The 401(k) borrowing process is relatively fast and you’ll avoid incurring the additional debt of a typical high-interest loan. But you’ll want to be sure it’s a need versus a want. Borrowing against your 401(k) has the potential to hurt your future.
What are the disadvantages to borrowing from your 401(k) plan?
There are some drawbacks to tapping into your retirement plan, that you’ll want to consider before taking any action, such as:
- If you leave or lose your job, payment must be made in full faster. Repayment is generally within five years. But, if you leave or lose your job, that repayment period shrinks to 60 to 90 days. The CARES act has extended this grace period and eliminated the tax penalty if you’ve been directly impacted by COVID-19.
- If you miss payments, be prepared to pay on your tax return. The outstanding balance borrowed will be considered taxable income for that calendar year. If you’re under age 59 ½, add a 10% penalty for making an early withdrawal from your 401(k) retirement plan.
- You’ll earn less in your 401(k) fund. In some cases, companies don’t allow you to continue to contribute to your 401(k) while a loan is outstanding. Plus, the longer it takes you to pay back the money, the greater chance you miss out on earning interest and a company match.
How much can you borrow from your 401(k)?
The IRS sets the 401(k) loan rules with a ceiling of $50,000 or 50% of your vested account balance, whichever is greater. However, in April 2020 the CARES Act increased that amount to $100,000 or 100% of your account balance, whichever is lesser. This exception is available to those impacted by COVID-19 until September 2020.
How does borrowing from your 401(k) work?
Not every 401(k) plan will follow the same rules. As a first step, review your plan description or talk to your plan provider. Some plans are strict about the purpose of your “loan,” while others have a “loan page” online to facilitate the process.
You’ll have to pay back the principal amount borrowed and interest on a certain schedule. Make sure you understand the amount of interest — often lower than a traditional loan — the schedule, and any penalties for defaulting on payments.
What are the alternatives to borrowing from your 401(k)?
The good news is you have options for accessing cash in an emergency, so you can choose what works specific to your financial need.
- Home renovation loans: Whether a planned renovation or an emergency repair, there are a variety of home renovation loans from the Federal Housing Administration, Fannie Mae, and Freddie Mac. Read more about each type here.
- Small business loans: From the new Paycheck Protection Program (PPP) to traditional Small Business Administration (SBA) loans, how much funding you need could determine the options you decide to pursue.
- Loans for personal debt or big purchases: If you’re a homeowner, there are several options to consider to offset personal debt (e.g. medical, college, divorce, etc.) as well as fund a major purchase such as a new home or car:
o HELOC: A home equity line of credit (HELOC) is like a credit card. For a period of 10 years, you’ll draw on the equity in your home as cash and make payments on interest only. After the draw period, repayment kicks in, typically over 20 years, with both principal and interest owed. If you intend to stay in your home indefinitely, a HELOC may be the choice for you.
o Reverse Mortgage: For those 62+, a reverse mortgage helps supplement your retirement income and allow you to stay in your home with no monthly mortgage payments. Be aware of the drawbacks of a reverse mortgage, however, such as high fees and inheritance.
o Home Equity Investment: For the debt-averse, home equity investments like Hometap’s are an attractive solution to short- and long-term financial needs. And like borrowing from your 401(k), a home equity investment is like borrowing from yourself. You can get access to fast cash with no payments, no interest, and no additional debt. Hometap invests in the future value of your home in exchange for a percentage of its equity. This flexible alternative can be used for any type of financial need — renovation, purchase, debts, small business expansion, etc. Unlike the $50,000 ceiling on 401(k) loans, a Hometap investment is up to $300,000 or 30% of your home’s total value.
Before choosing a means to fund your financial need, compare all your options to see which one makes most sense for your situation. Finding the best option can allow you to meet your short-term financial need and long-term financial goals — without one being at the expense of the other.
See if a Hometap Investment is the right fit for you.