The primary benefit of 401k loans is that the proceeds are not subject to taxes or the ten-percent penalty fee except in the event of default. The government does not set guidelines or restrictions on the uses for 401k loans. Many employers, however, do; these can include minimum loan balances (usually $1,000) and the number of loans outstanding at any time in order to reduce administrative costs. Additionally, some employers require that married employees get the consent of their spouse before taking out a loan, the theory being that both are affected by the decision.
401k Loan LimitsIn most cases, an employee can borrow up to fifty-percent of their vested account balance up to a maximum of $50,000. If the employee has taken out a 401k loan in the previous twelve months, they will only be able to borrow fifty-percent of their vested account balance up to $50,000, less the outstanding balance on the previous loan. The 401k loan must be paid back over the subsequent five years with the exception of home purchases, which are eligible for a longer time horizon.
401k Loan Interest ExpenseEven though you’re borrowing from yourself, you still have to pay interest! Most plans set the standard interest rate at prime plus an additional one or two percent. The benefit is two-fold: 1.) unlike interest paid to a bank, you will eventually get this money back in the form of qualified disbursements at or near retirement, and 2.) the interest you pay back into your 401k plan is tax-sheltered.
The Drawbacks of 401k LoansThe biggest danger of taking out a 401k loan is that it will disrupt the dollar cost averaging process. This has the potential to significantly lower long-term results. Another consideration is employment stability; if an employee quits or is terminated, the 401k loan must be repaid in full, normally within sixty days. Should the plan participant fail to meet the deadline, a default would be declared and penalty-fees and taxes assessed.
You can learn more about the pros and cons of 401k loans in Should I Take a 401(k) Loan?.
401k Hardship WithdrawalWhat if your employer doesn’t offer 401k loans or you are not eligible? It may still be possible for you to access cash if the following four conditions are met (note that the government does not require employers to provide 401k hardship withdrawals, so you must check with your plan administrator):
- The withdrawal is necessary due to an immediate and severe financial need
- The withdrawal is necessary to satisfy that need (i.e., you can’t get the money elsewhere)
- The amount of the loan does not exceed the amount of the need
- You have already obtained all distributable or non-taxable loans available under your 401k plan
If these conditions are met, the funds can be withdrawn and used for one of the following five purposes:
- A primary home purchase
- Higher education tuition, room and board and fees for the next twelve months for you, your spouse, your dependents or children (even if they are no longer dependent upon you)
- To prevent eviction from your home or foreclosure on your primary residence
- Severe financial hardship
- Tax-deductible medical expenses that are not reimbursed for you, your spouse or your dependents
All 401k hardship withdrawals are subject to taxes and the ten-percent penalty. This means that a $10,000 withdrawal can result in not only significantly less cash in your pocket (possibly as little as $6,500 or $7,500), but causes you to forgo forever the tax-deferred growth that could have been generated by those assets. 401k hardship withdrawal proceeds cannot be returned to the account once the disbursement has been made.
Non-Financial Hardship 401k WithdrawalAlthough the investor must still pay taxes on non-financial hardship withdrawals, the ten-percent penalty fee is waived. There are five ways to qualify:
- You become totally and permanently disabled
- Your medical debts exceed 7.5 percent of your adjusted gross income
- A court of law has ordered you to give the funds to your divorced spouse, a child, or a dependent
- You are permanently laid off, terminated, quit, or retire early in the same year you turn 55 or later
- You are permanently laid off, terminated, quit, or retired and have established a payment schedule of regular withdrawals in equal amounts of the rest of your expected natural life. Once the first withdrawal has been made, the investor is required to continue taking them for five years or until he/she reaches the age of 59 1/2, whichever is longer.