Drill Down: What a 401k Loan Costs You

Borrowing money costs you. You pay interest to borrow money, regardless of where the money comes from. There is a myth out there that it’s free to borrow money from your own 401k because you are borrowing from yourself. That’s completely untrue.

When you borrow money from your 401k, you have to repay the loan with interest. That looks like a cost, doesn’t it? Your 401k account is receiving interest payments from YOU, when it could have been receiving income from someone else. Which do you think is better?

Numerical example:

Suppose that you have $1,000 in a 401k account that is earning ten percent returns. You are thinking about borrowing $400, and your plan requires that you pay ten percent interest.

If you don’t borrow any money from your 401k plan, after one year your plan has increased in value from $1,000 to $1,100. (That’s a ten percent gain on a starting value of $1,000.)

Now suppose that you borrow $400 from your account, paying it back in one year. You have to pay back $440. (That’s the $400 loan plus ten percent interest.) The money that remained in your 401k account, $600, earned ten percent interest. So that money grew to $660. Adding the $440 from the loan brings your 401k account up to $1,100. That’s exactly where it would have been without the loan.

Now what about your personal finances? You borrowed $400, paid back $440 counting interest, so the loan cost you $40. That is ten percent interest.

If you do borrow money from your 401k, you’ll generally have five years to repay the loan, or 15 years if the purpose was to buy your first home. However, your plan may have different rules, so check with your employer before making the decision.

Bill Says: Even though you “paid the interest to yourself” on your 401k loan, you are poorer by the amount of the interest that you paid.

If you have to borrow the money, the 401k may be a good way to borrow it. Just remember that it is not free.

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Drill Down: Taxes and Penalties from 401k Loans

There are some dangers in borrowing from your 401k that you should be aware of. First, let’s suppose that you have to change jobs after you borrowed the money, but before you were able to repay the loan. Perhaps you have a better opportunity somewhere else, or maybe you were laid off. In most cases, you have to repay your loan immediately.

Here’s what happens if you DO NOT pay back your 401k loan in time: The IRS will say that you have withdrawn money from your 401k plan and therefore are responsible to pay the income tax. Assuming that you borrowed $400 and haven’t repaid it by the time you leave your employer, you will now be responsible for $400 of “taxable income.” Since you found yourself needing to take out the loan in the first place, you likely do not have the cash necessary to pay the taxes.

That’s not all. If you are under 59½ years old, the IRS will say that you took an early withdrawal from your plan. You are subject to a penalty of ten percent of what you borrowed, in addition to the taxes. And again, you may not have the cash you need to pay the IRS.

Bill Says: Having a debt you cannot pay is bad. Having a debt to the IRS that you can’t pay is very, very bad.

Had you borrowed the money anywhere else, taking your time to pay off the loan would not have cost you taxes and penalties to the IRS. So keep in mind that, when you borrow from your 401k, you may have to suddenly come up with enough money to pay your loan off quickly.

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Drill Down: Good Reasons to Borrow from Your 401k

Have you caught a skeptical tone in my voice about 401k loans? I don’t much care for them, but at times it is the best choice.

Here’s a situation where the 401k loan is perfect. Your car’s transmission is making very bad noises, and you’ll need to lay out $2,000 to get it running again. You need your car to get to work and keep your job, let’s say. I further assume that you have a large enough credit limit on your credit card that you could pay for the transmission that way, but the interest rate would be 20 percent or more.

In this situation, go ahead and borrow from you 401k. (It may take a while to process the loan, though, so start the process now.) If your car is ready before the loan is processed, go ahead and put the repair on your credit card. When the 401k loan comes through, use that to pay the credit card bill.

Why is this an appropriate use for a 401k loan? First, it’s borrowing with a good purpose. If, instead of maintaining the transportation that enables you to work, you had asked about a vacation to Hawaii, I would have said do without. Buy a tent at a yard sale and go camping. Do something that you can afford. But in this case, keeping your job is always a high priority.

The second factor that makes this a good time to use the 401k loan is that you have credit available if you need to pay off the loan. So if you get a great new job offer before you’ve repaid the 401k loan, here’s what you do. Use your credit card account to pay off the loan. (Use one of the checks that your credit card company sends you.) That way there are no taxes or penalties for early withdrawal due to the IRS. You will have to pay a high interest rate, but that’s better than paying tax and penalty.

Bill Says: You may have an idea for something not quite so straightforward as either the car repair example or the Hawaiian vacation. Let me give you my general advice: You have to get your spending under control because you cannot spend more than you earn. Debt can let you do that temporarily, but it the long run you will be poorer because of it.

What are some other good examples of borrowing from your 401k? I can’t think of too many. If the spending is exceptionally prudent, such as a young family that would save money by owning a washer and dryer rather than going to the laundromat, then I’ll give you a pass. For the most part though, get by on what you earn and don’t borrow. Don’t believe that because you are borrowing from your 401k you are less in debt than if you were to borrow from a bank.

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Drill Down: Hardship Withdrawals

If you are 59½ years old, you can take money out of your 401k without penalty. You will still have to pay regular income tax on the distribution, but you will not be liable for any penalty.

If you are younger than 59½, there are a few reasons for which you can take a distribution without having to pay a penalty (though you are still accountable for the income tax). The permissible situations for withdrawing money early without a penalty include:

• Having unreimbursed medical expenses that are more than 7.5% of your adjusted gross income
• Medical insurance (The distributions cannot be more than the cost of your medical insurance)
• Being disabled
• Using the distributions to buy, build, or rebuild a first home

There are a few other possibilities; check with the Internal Revenue Service for the details.

In other cases, a hardship withdrawal will cost you both tax plus a ten percent penalty. To be eligible at all, your plan has to allow it. The plan may allow withdrawals for expenses considered immediate and heavy, including:

• Medical expenses
• Costs relating to the purchase of a principal residence
• Tuition and related fees
• Payments necessary to prevent eviction from, or foreclosure on, your home
• Burial or funeral expenses
• Certain expenses for the repair of damage to your home

Is This Your Best Solution?

Before I go on to describe all of the requirements you need to meet in order to take a hardship distribution withdrawal from your 401k, a discussion on the reasoning is in order. If you’re looking to tap into your retirement money (and thereby losing all of that growth advantage), you clearly must be facing some pressing needs. Is a hardship withdrawal the answer?

Assuming you meet all of the requirements below, it may be. But quite often, people investigate the possibility of making a 401k hardship withdrawal to pay off mounting credit card debt. As you’ll see below, that’s not even a permissible reason, and it most likely doesn’t address the real problem if the accumulated debts are due to bad habits.

If the debt is due to unwise spending habits, altering those habits would be far more helpful than a 401k withdrawal. Change your habits if you need to, and keep the money in your 401k. The actual cost to your retirement security is much greater than the amount you withdraw, for the total cost to you is what your money would have grown into by the time you retire had you let it be.

You don’t want to use a hardship withdrawal unless you absolutely must. Given a choice, you want to leave as much money in your 401k plan so that it can grow, tax deferred, to support you during retirement.

Requirements
If you determined that you still need to make a hardship withdrawal, check if your situation meets the following requirements laid out by the IRS—and yes, they are numerous. Your hardship disbursement request must:

1. Constitute an immediate and heavy financial need
2. Be necessary to satisfy that financial need (i.e. you can’t pay for it in some other way—perhaps with credit cards)
3. Not exceed the amount that you actually need
4. Follow exhaustion of all other distributions and nontaxable loans available through your 401k plan
5. Not be followed by contributions to your 401k for 6 months following the withdrawal

Each individual’s plan will contain the exact requirements for making such a withdrawal, 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 59½, 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.

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