From time to time, circumstances may warrant taking money out of your 401(k) account. If you’re older than age 59½, become disabled, get divorced (in specific situations), or die, money can be removed from your 401(k) without paying the 10% federal income tax penalty for early withdrawals. (Of course, income taxes will still be due.)
But, what if you are younger and have a pressing need for immediate funds? The Internal Revenue Service (IRS) allows two other methods for removing money from your 401(k) plan account before retirement: 1) a qualified hardship withdrawal, and 2) a loan.
Qualified Hardship Withdrawals
Subject to certain limitations, the IRS generally allows you to take a qualified hardship withdrawal from only the employee’s elective contributions to the 401(k) plan, if the funds are used for the following purposes:
- To pay qualified higher education costs for yourself, your spouse, or your dependents.
- To purchase or make payments to avoid foreclosure of your principal place of residence (or if you rent, to prevent eviction).
- To pay qualified uninsured medical costs incurred by you, your spouse, or a dependent, or which are necessary for such persons to obtain medical care.
Keep in mind, however, that a qualified hardship withdrawal does not avoid the 10% penalty for early withdrawals. Also, because you are permanently removing money from your 401(k), income taxes will be due.
Borrowing from Your 401(k)
Many 401(k) plans allow participants to borrow a portion of their account balance. By law, loans cannot exceed the lesser of 1) 50% of your vested account balance or $10,000, whichever is more, or 2) $50,000, minus any outstanding loan balance from the past 12 months.
Generally, loans must be repaid with interest within a set period of time (usually five years). Interest rates are comparable to commercial loans. As long as the terms of the loan are met, there is no 10% penalty for early withdrawal or income tax due (withdrawals not paid back are income taxable events).
Before you consider taking a loan from your 401(k) account balance, you should carefully review your financial situation. The first thing you need to ask yourself is whether or not the loan will be used in a prudent manner. For instance, taking out a loan to purchase a second home may make more sense than borrowing the money for a vacation. Let’s take a quick look at some pros and cons of borrowing from your 401(k).
The pros:
- When you pay back the loan, you are, in effect, paying interest to yourself. It all goes back into your account.
- As long as the interest rate equals or exceeds the rate of return you are earning on the unborrowed portion, you are not hindering the long-term growth of the account.
The cons:
- The interest portion of loan repayments generally is not tax deductible.
- These loans usually have short-term limits. Amounts not repaid on time will be viewed as taxable withdrawals by the IRS and may be subject to penalties.
- If you leave the company, your employer may demand full repayment within 60 days; you might owe taxes (and possibly penalties) on the unpaid balance.
Prudence Pays
If you need to borrow or take a hardship withdrawal, you should consider all credit sources available to you and select the source best suited to meet your needs. Tapping your 401(k) might make sense in certain situations, but consider every option first.
CRN200711-2010156
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