Personal Finance

Taking a 401K Loan and Hardship Withdrawal Rules

401K Loan and Hardship Withdrawal Rules

401k retirement plans are intended to grow tax-deferred, with no withdrawals until you hit retirement age. However, since we don't live in a perfect world, especially with the recent economic environment and layoffs. As a result, items may come up that require you to have immediate available funds in the event of the death of spouse, big medical bill, etc. Regardless, there is an opportunity to withdraw money from your 401k or other retirement account.

401k Loan Benefits:

The primary benefit of acquiring a 401k loan from your retirement plan is that the proceeds of this loan are exempted from taxes and without penalty. There are no restrictions on the use of a 401k loan acquired from your plan. However, some plan administrators have implemented a few details like number of outstanding loans and the minimum balances associated with that amount. In a nutshell, companies do this to decrease the amount of administrative costs that they incur.

Limits of Loan from 401K Plan

When would a 401K loan provide a reasonable solution for your needs? The typical stipulations of 401K borrowing allow you to take up to 50% of your retirement plan balance or $50,000, whichever is less. You are typically required to pay the loan back within a period of 5 years. There is some reasonable thoughts you need to exercise when putting this decision into effect. A 401K loan for hardship is a valid approach provided that it is not a distribution. Don't forget, there is a distribution penalty on all loans taken from a retirement plan.

401k loan

Interest on 401K Loans

The laws that relate to a 401K loan do not place any restrictions on the use of the proceeds, expect that the loans must be made available to all employees. However, a company can restrict the reasons for these loans if they choose to do so. A few businesses have declared that loans are restricted for the purposes of preventing eviction from your home, paying amounts for higher education, or paying for health expenses. Generally speaking, employers offering a 401K loan provision will restrict the number of loans. Usually, the amount of the loan is deducted from the employee's income each week and the interest rate is charged at the prime rate plus 1%.

What to Think About Before Taking a 401k Loan.

Other factors things to think about when pondering whether or not to take a 401K loan include, but are not limited to:

  • If you are planning to leave your job, often the unpaid loan will be automatically labeled as income. The amount that was borrowed could then be subject to both income tax and the 10% 401K penalty. You can be effectively losing interest on the amount of the distribution.
  • Payments to satisfy a loan from your 401k come from after tax dollars. Amounts you contribute to the loan has quite a bit of opportunity costs when compared with lost investment potential or interest earning activity.

As previously mentioned, there are many positives to taking a 401K loan. Credit checks are non-existent and the process for getting the loan is relatively seamless. In addition, when you pay back the loan interest you are really just paying yourself and the interest associated with the transaction is tax sheltered. You don't pay taxes on the interest on the loan until retirement.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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