Retirement plan decisions made easy
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Many 401k plans, but not all, allow you either to borrow money from your own account or to make a withdrawal in a time of hardship. If you need money from your 401k, a loan is usually better than a hardship withdrawal because you can pay it back, allowing your 401k account to continue growing as it would have originally. A hardship withdrawal wouldn’t permit you to contribute any additional money into your 401k for six months. You’ll have to check the rules specific to your plan to know what is allowed.
If you’re considering a 401k loan, remember that loans always incur a cost to you in interest, regardless of whether you’re taking it from your 401k or elsewhere. Even though you are paying the interest to yourself with a 401k loan, you will always be poorer by the amount of interest you paid.
Drill Down: What a 401k Loan Costs You
There are some dangers in borrowing from your 401k of which you should be aware. If you DO NOT pay back your 401k loan in time (i.e. maybe you got a better job offer or you were laid off), you could face some costs that you are not prepared to pay. Were that to happen, the IRS will say you took a withdrawal and are responsible for the taxes, in addition to the ten percent early withdrawal penalty you would owe if you’re younger than 59˝ years old. And both of these could become due at a time when you are least likely to be able to pay them. If you’re considering taking out a 401k loan or hardship withdrawal, be sure to read the complete chapter. There are a lot of requirements by both your specific plan provider and the IRS, especially for the hardship withdrawals.
Drill Down: Taxes and Penalties from 401k Loans
Though I don’t think there are many good reasons to take out a 401k loan, there are a few, but rest assured paying for a vacation to Hawaii is not one of them. An example of a good reason to take out a 401k loan would be to fix your car’s transmission that just fell out. We’ll assume you need your car to keep your job and that you have sufficient credit to pay off the loan immediately should it be necessary (to avoid all those taxes and penalties).
Drill Down: Good Reasons to Borrow from Your 401k
If you’re considering a hardship withdrawal, you’ll have to make sure that your situation meets certain requirements. Your hardship distribution request must:
- Constitute an immediate and heavy financial need
- Be necessary to satisfy that financial need (i.e. you can’t pay for it in some other way—perhaps with credit cards)
- Not exceed the amount that you actually need
- Follow exhaustion of all other distributions and nontaxable loans available through your 401k plan
- Not be followed by contributions to your 401k for 6 months following the withdrawal
A hardship withdrawal really should be your last resort and not the quick fix to bad spending habits (using it to pay off credit card debt—a frequent reason—is not even an acceptable reason.)
Drill Down: Hardship Withdrawals
Each individual’s plan will contain the exact requirements for making a withdrawal or a loan, so make sure to check your specific plan. This sounds complicated, but it’s good to know that you have some options with your 401k when you need it. Just remember, if you’re under 59˝, you will probably have to pay the 10% penalty tax for the early withdrawal, but you will not be required to repay the disbursement amount back to your 401k plan as you would with a loan.
You are not logged in. Log in or create an account.
Click here to sign up for our monthly newsletter delivered via email.
Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
» Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
The 401k ebook is available in text, audio, and video formats. The current selected format is text. You may also switch to the audio or video formats by clicking on the icons at the top of this page.