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Not All 401 Plans Let You Take A Loan
While the law allows companies to offer 401 loans in their plans, they are not required to do so. In fact, some employers oppose the entire idea of 401 loans, because management or owners believe that retirement assets in these accounts should be as sacrosanctheld beyond reach and out of the way of temptation. Additionally, some employer plans only permit 401 loans for specific purposes.
During the Great Recession of 2008 and 2009, a number of people who had been living with too much debt found themselves unable to make credit card payments or pay their mortgage.
Instead of declaring bankruptcy or going into foreclosure, many attempted to withdraw from their 401 assets, which triggered regular income taxes plus a 10% penalty for those under the age of 59 1/2.
Many decided to go with a loan until they found out that their company plan didn’t offer 401 loans for that very situationto prevent people from losing their retirement assets when markets fluctuate and cause other losses.
Under What Circumstances Can I Take A 401 Loan
If your 401 plan allows loans, you can generally take a loan when the following conditions are met:
- The amount of the loan cannot exceed the lesser of:
- $50,000, minus your highest outstanding loan balance during the past 12 months
- The greater of $10,000 or ½ of your vested account balance
- The term of the loan cannot exceed five years. Your plan may allow a longer term for loans used to purchase a principal residence.
- You must agree to make substantially level repayments not less frequently than quarterly over the life of the loan.
- The loan must be subject to a legally-enforceable agreement.
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Next Steps To Consider
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917
Option : Roll Over Your 401 Into An Ira
Instead of keeping your funds in a 401, you may also choose to roll over your plan into an IRA. Youll do this with a bank or brokerage firm separate from your employer. This is a common choice for people who are leaving the workforce or for those who dont have an employer that offers a 401 plan.
The main benefit of an IRA versus a 401 is more flexibility in withdrawing money penalty-free before reaching the age of 59 ½. You also have direct access and more control over your investment options. You may have other investments and can now move this money to the same brokerage so that everything is in one plan, which consolidates logins.
If you choose to withdraw money from a rollover IRA, it may be used for a qualifying first-time home purchase or higher education expenses in addition to the exceptions for 401s.
The drawbacks of an IRA is that youll lose some hardship distribution options as well as qualified status, which means less protection of your assets. For example, if you were to be sued, some states would allow money in IRAs to be collected but not if it was in a 401.
What May Be The Pros Of Rolling The Money Over To An Ira
- You dont like the old or new plans investment options better than what you can access in an IRA
- You dont like the old plan and/or youre concerned youll lose track of the money if you leave it in the old plan, and the new plan doesnt accept rollovers plans, you can roll them all into the same IRA or IRAs)
- Fees may be higher than a no-load IRAs in both your old and new 401 plans
- If your balance is high enough, you may be able to access free or low-fee investment advice from the manager of your rollover IRA
Loans To Purchase A Home
Regulations require 401 plan loans to be repaid on an amortizing basis over not more than five years unless the loan is used to purchase a primary residence. Longer payback periods are allowed for these particular loans. The IRS doesn’t specify how long, though, so it’s something to work out with your plan administrator. And ask whether you get an extra year because of the CARES bill.
Also, remember that CARES extended the amount participants can borrow from their plans to $100,000. Previously, the maximum amount that participants may borrow from their plan is 50% of the vested account balance or $50,000, whichever is less. If the vested account balance is less than $10,000, you can still borrow up to $10,000.
Borrowing from a 401 to completely finance a residential purchase may not be as attractive as taking out a mortgage loan. Plan loans do not offer tax deductions for interest payments, as do most types of mortgages. And, while withdrawing and repaying within five years is fine in the usual scheme of 401 things, the impact on your retirement progress for a loan that has to be paid back over many years can be significant.
If you do need a sizable sum to purchase a house and want to use 401 funds, you might consider a hardship withdrawal instead of, or in addition to, the loan. But you will owe income tax on the withdrawal and, if the amount is more than $10,000, a 10% penalty as well.
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What Happens If You Took Out A 401 Loan From Your Old Plan
It used to be that if you had an outstanding balance on a 401 loan and left employment, you had very little time to pay it all back, or the remaining balance would become a de-facto early withdrawal, with all the negative consequences mentioned above.
Following the 2017 Tax Cuts and Jobs Act, if you took out a 401 loan from your old plan and are leaving employment for any reason before paying it all back, you can continue making payments to a rollover IRA.
This new tax law gives you until your tax filing deadline to finish paying back the loan in full before considering the unpaid balance an early withdrawal, subject to all the consequences of such a withdrawal.
What Are The Pros And Cons Of Taking A 401 Loan
- Convenience Requesting a loan is usually a straightforward process with little to no documentation required. Repayments are usually made automatically by payroll deduction.
- Interest The interest earned on your loan is paid to your 401 account, not a bank. The interest rate is generally lower than what you would pay elsewhere – usually prime + 1 to 2%.
- Repayment flexibility You define the repayment period of your loan.
- Lost earnings While your 401 account earns loan interest, the amount is often less than the earnings you would have received on the investments sold to take the loan. These lost earnings can materially reduce the amount of your nest egg at retirement.
- Repayment upon termination Most 401 plans require the full repayment of an outstanding loan balance upon termination of employment.
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Pros And Cons Of 401 Loans
Pros of 401 loans:
- You dont pay a 10% penalty or tax on the money you borrowed if you pay it off on time
- It is easy to qualify for these loans
- You can borrow up to $50% of your account savings but no more than $50,000. This is a large amount to help you take care of your projects.
Cons of 401 loans:
- It is hard to change your 401 loan terms
- You lose the opportunity to invest your money
- Every loan comes with risks. So, you will pay a 10% penalty and taxes on the defaulted balance if you are not at least 59 ½.
- You will have a short time to pay off your loan when you quit your job
This Time Lets Start With The Cons Because Theyre Overwhelming
More than 8 in 10 young employees who leave their job simply cash out their old 401 balances, especially when the balances are relatively small.
In most cases, this is foolish in the extreme. Say youre leaving your old job when youre 25 and you have $2500 in your old plan. Youre starting a new job, and your total marginal tax rate is 30%. When you cash out the $2500, the plan will withhold 30%, 20% toward taxes and 10% early-withdrawal penalty. At tax time, youll actually owe another ~10% because your marginal tax rate isnt 20%, its 30%.
This means that out of the $2500, you end up with just $1500.
Further, if we assume a long-term average annual real return of 6%, and that youll retire in 42 years at age 67, your $2500 would have grown to almost $29,000.
As you can see, youd be grabbing $1500 now, but youll lose $29,000 when youll need the money to be able to retire.
Not a super-smart choice in most cases.
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How Long Do You Have To Move Your 401 After Leaving A Job
You dont have to move 401 after you leave a job. You can just keep it there if youd like. But if you initiate a rollover after you leave your job and they mail you a check, then you have 60 days to roll over these funds into an eligible retirement account. If you dont do it within 60 days, then you may be subject to early withdrawal taxes.
What Happens If You Leave Your Job
When you take out a loan from a 401, you may have no intention of leaving your current employer. But if you receive a better job offer, or are laid off or otherwise leave, you could be required to pay the loan back in full or face some serious tax consequences.
Employees who leave their jobs with an outstanding 401 loan have until the tax-return-filing due date for that tax year, including any extensions, to repay the outstanding balance of the loan, or to roll it over into another eligible retirement account. If you cant repay it, the amount of money you still owe will be considered a deemed distribution and could be taxed as it would be if you were to default on the loan.
That means if you left your job in January 2021, you would have until April 18, 2022 when your 2021 federal tax return is due to roll over or repay the loan amount. Prior to the Tax Cuts and Jobs Act of 2017, the deadline was 60 days.
If you cant repay the loan, your employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That amount is typically considered taxable income and may be subject to a 10% penalty on the amount of the distribution for early withdrawal if youre younger than 59½ or dont otherwise qualify for an exemption.
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What Happens To A 401k Loan When You Quit
If you happen to leave your job while you have a 401k loan outstanding, you need to repay that loan within 60 days of quitting. If you fail to repay the 401k loan, the IRS will view it as a withdrawal from your 401k. This will result in taxes and penalties. Obviously, this is not a good result and its best to avoid this if possible.
If paying back the loan within 60 days, is going to be impossible, its often better to borrow from somewhere else in order to pay it back. Thats how important it is to not take withdrawals from 401ks. You can use your HELOC, an unsecured line of credit, or a company like Lending Club to help you pay back your 401k loan immediately. Then, pay off those new loans as quickly as you can.
Am I Required To Pay Off My 401k Loan In Full
Even if you are only two years into a five-year 401 loan, you will likely be required to repay what you owe. If you don’t repay the amount owed, it will be considered an , and will trigger penalties and taxes. You have until tax day the following year to pay those fees and penalties.
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You Can Roll Your Old Plan Into Your New Employer’s Plan
If you don’t want to keep your money in your previous employer’s plan, you can choose to roll over your 401 account to your new employer’s plan.
Check with the administrator of your new plan to find out if you can roll it over right away, or if you have to wait until you’re eligible to participate in the plan to do so.
This option lets you keep all of your 401 money together in one account.
What Are The Tax Consequences Of A 401 Loan Offset
For the most part, the offset of an outstanding loan balance is treated like a cash distribution for Federal income tax purposes. Its taxable at ordinary income rates and subject to a 10% premature distribution penalty if the employee is under age 55.
The key difference? There is no 20% mandatory tax withholding unless the offset occurs simultaneously with a cash distribution.
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Cases Where You Might Need To Do This Anyway And How To Minimize The Damage
If you absolutely must take the money to cover an emergency , you can do so. In some cases, you may not owe the 10% penalty, and if the plan was a Roth 401 you wont even owe taxes.
If this is your situation, here are your three steps:
What You Can Do With A 401 Balance When You Leave
If youre quitting, like I did that first time, or suffering a lay-off like my second time, you have either 3 or 4 options, depending on your account balance.
So, which should you choose?
There is no answer thats right for everyone. As I like to say, personal finance is just that personal. Whats right for me now may not be right for you, and may even be wrong for me at a different time.
Below well look at the pros and cons of each option.
But first, note that if your balance is under $1000, your old employer may simply make the choice for you, withholding 20% toward your possible tax liability and sending you a check for the rest. See below for more details of what that could mean.
If your balance is over $1000 but less than their threshold for allowing the money to stay in the plan , your old employer must give you at least 30 days notice about your right to withdraw the balance. If you fail to respond, they will most likely establish a rollover IRA for you.
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Cashing Out A 401 Is Popular But Not So Smart
Intellectually, consumers know that cashing out retirement accounts isnt a smart move. But plenty of people do it anyway. As discussed, you may be forced out of your former plan based on your account balance, but that doesnt mean you should cash the check and use it for non-retirement-related purposes. In the long run, your financial future will be better served by rolling the money over into an IRA or, if applicable, your new employers 401 plan.
A 2020 survey by Alight, a leading provider of human capital and business solutions, found that 4 out of 10 people cashed out their balances after termination between 2008 and 2017. About 80 percent of those who had an account balance of less than $1,000 cashed out, while 62 percent who had balances between $1,000 and $5,000 did the same.
Based on historical rates of return, a $3,000 cash-out at age 24 leads to $23,000 less in your projected account balance at age 67 a total of 5 percent. Even a small amount of money invested into a retirement vehicle today can make a big difference in the long run.