401k Loan or Withdrawal? The Pros and Cons

Times have been tough in the past few years. Unemployment has been high, home prices have fallen, and it has been harder to qualify for loans with reasonable interest rates.

If you have high interest credit card debt, need to cover a major medical expense, or make a large purchase, using money in your 401k account is a solution worth investigating. You may benefit from taking out a 401k loan or from withdrawing money from your account. Of course, you need to have an account with funds that you are permitted to borrow from.

Even if you have money in a 401k account, it is important for you to understand the pluses and minuses of using your retirement account, so that you make the best decision.

A Loan is not a Withdrawal

A loan is not a withdrawal. The rules for borrowing money from your 401k account are not the same as the rules about withdrawing money from your account. While there are some general rules set by the government, each 401k plan can have its own rules. Always check with your 401k plan administrator to find out the rules that govern your account.

For instance, some 401k plans do not allow loans. Some do not allow withdrawals that do not meet the IRS definition of a hardship withdrawal, which are allowed for the following reasons.

• To buy a primary residence
• To prevent foreclosure or eviction from your home
• To pay college tuition for yourself or a dependent, provided the tuition is due within the next 12 months
• To pay non-reimbursed medical expenses for you or your dependants

If you’re less than 59 ½ years old, your withdrawal is subject to a 10% early withdrawal penalty, even if you qualify for a hardship withdrawal. There are certain times when an early withdrawal can be made without a 10% penalty, including when:

• You become totally disabled.
• You are in debt for medical expenses that exceed 7.5% of your adjusted gross income.
• A court order requires you to give money in your account to your divorced spouse, a child, or a dependent.
• Your job ends (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.

Pros of a 401k loan

Before you withdraw money from your 401k, look at borrowing from your account. Borrowing has some distinct advantages over withdrawing, including:

• No 10% penalty– A 401k loan is not subject to the 10% penalty, no matter your age, as long as you pay it back as agreed.
• Pay interest to yourself– While you will pay interest on your loan, all the interest that you pay goes back into your own account. The interest rate is usually a bit over the prime interest rate. Check with your plan administrator to determine the exact interest rate you’ll pay.
• No financial hardship is necessary– You can take out a loan without having a financial hardship. You get to decide if borrowing will improve your financial position.
• No credit check– Most loans require strong credit or will smack you with very high interest if your credit is less than excellent. Your 401k loan is not related to your credit. Therefore, if you have bad credit and can’t qualify for a loan or only for one with high interest, a 401k loan can be your best borrowing option.

Disadvantages of 401K Loan

A 401k loan has disadvantages, too. To make a fully informed decision, make sure you consider:

• Effects on Retirement Account– You can lose growth in your investments, with smaller holdings in your account. If you are unable to make your normal contributions during the time you’re paying back your loan, you harm your ability to build your retirement fund. If your employer matches your contribution, then you take a bigger hit, if you’re unable to contribute and miss out on the employer match.
• Your Loan Could End up as a Withdrawal– Different actions can cause your loan to lose its loan status and end up as a withdrawal, subject to 10% penalty and income taxes.
  • If you can’t pay the loan back as agreed, your outstanding loan balance will be viewed as a withdrawal and subject to 10% early withdrawal penalty and income taxes.
  • If you leave your job by choice or due to termination, you have to pay back the loan in full or be hit with both the 10% penalty and income taxes. You usually have two to three months to repay the loan, after a change in jobs, before you are subject to the penalty.

• Potential Tax Problems– If your loan does end up as a withdrawal, it is up to you to make sure it is reported properly on your taxes. Too often, people make mistakes that the IRS doesn’t catch for a few years. When they do catch it, they hit the taxpayer with years of interest and penalties.
• Bankruptcy and 401K loans– In general, money you borrow is not as safe as the money that is in your 401K account. The money in your 401K is generally beyond any creditor’s reach. Money you borrow and are holding is vulnerable. It may be subject to forfeiture and may also harm your ability to qualify for a bankruptcy.

Check with Your Plan Administrator

Rules for a 401k loan or taking a withdrawal can vary from plan to plan. The smartest first step you can take, if you want to access money in your retirement account is to speak with your plan administrator. Find out whether you’re eligible to borrow or withdraw, how much you can take out, whether you are subject to penalties, and how long you have to pay back the loan.

Regarding the penalties and taxes, your best option is to consult with a tax preparer, in order to avoid any surprises come tax time. Even if taxes are withheld from a withdrawal, you may owe additional taxes, depending on the other income on your return and how it is taxed.