It appears really simple. You are in dire need of cash due to financial difficulty and you come to a decision to take hardship loans from your 401k account. You find this financial assistance option to be very acceptable. After all, you’ve contributed all those funds. You just have to pay the principal and interest rate back into your account. However, as with most financial assistance opportunities, procuring a hardship loan is not as simple as it sounds.
In actual fact, for many people, a loan modification hardship from their employer-sponsored retirement account is not always the best solution.
What are the Rules?
If your 401k account permits loans—actually most do—you can have access to as much as 50% of your contributed funds or $50,000, whichever is lower. Typically, you will be given five years, being the maximum, to recompense the loan. But, if you are borrowing money for your first time home purchase, you will normally be granted with longer payback term.
Prior to learning the pros and cons of a financial hardship loan, a very important thing to remember is that: if you are experiencing a financial emergency, and you are only left with two choices of either to borrow from your 401k plan or pull your money from the account through a 401k hardship withdrawal—which has the same rules stipulated in IRA hardship withdrawal—before you even become 59 ½ years of age, the solution is simple. By all means, just borrow your retirement funds. That’s because you will not incur penalty due to borrowing, but you will have to shoulder 10% on early withdrawals.
The Pros of Loans Against 401k
- Worry no more about credit checks. You are not required to apply for the loan, and you are allowed to make early plans since you know that you will procure the loan.
- Low interest rate means higher possibility of paying back the loan immediately. You only need to reimburse the rate set by the account, commonly a couple of percentage points than the prime rate.
- Receiving good returns. If you keep a money market account that is making 3% and you are necessitated to pay yourself back at 6%, this seems to be a pretty good deal.
- The rate of interest is tax-sheltered. Therefore, you are not obligated to pay for the taxes on the interest rate until you reach your retirement when you distribute money from your 401k plan.
- It’s expedient. A 401k hardship loan application only requires you to submit a short loan form or just simply make a phone call to the plan administrator.
The Cons of Loans Against 401k
While you may be delighted that there is no credit check, you should be reminded that you are not borrowing money from anyone. You are spending what is supposed to be saved for your retirement.
The impact of this loan is that you are mislaying significant amount of interest. As a result, you have less money in your retirement account to invest in good assets and to generate interest. The money you get from your account is bound not to appreciate in value from dividends, interest, and capital gains in concurrence with the rest of your investments contained in your portfolio. Remember that you are not actually borrowing money like what a student hardship loan offers. All you are doing is spending your money from your retirement account.
The money you loan is not tax-sheltered anymore. Although you’ll repay the 401k loan from your monthly salary or from your savings account, such payments are placed back in your account as after-tax dollars. For example, if your monthly payment of interest amounts to $300 and you are on the 28% tax bracket, you’ll be forced to make gross earnings of $416 to cover the $300 payment. And when you reach your retirement and you carry out distributions, you will have to pay taxes once again.
Unless you consistently repay the loan, it will be considered as a premature distribution. You will incur state and federal income taxes and another 10% penalty if you are not yet 59 ½ years of age.
Your loan is not considered tax deductible. Because this loan is deemed as consumer loan like loans for unemployed, you don’t get any tax advantage.
Hardship Loan Caution
Hardship loans significantly impact your thinking towards retirement. At all costs, you should not tap your retirement savings account because it’s very easy to be in the habit of getting your 401k money than savings for things you want or need. You can use our free 401k Cash Out calculator to find out just how much money you’ll be losing if you withdrawal or cash out your 401k early!