As a group, Americans are not particularly good at saving money. The national savings rate has hovered between 3 and 5% for the past 25 years, a far cry from the world’s better savers. Coincidentally, 3% is also the default percentage for many workers when they initially enroll in their company’s 401(k) plan. Although more people are enrolling in optional retirement savings plans, the average amount in 401(k) plans has changed little in the past ten years, staying around the $100,000 mark.
“Compound interest is the most powerful force in the universe,” is a quote often attributed to Albert Einstein, by all accounts a reasonably bright guy. While it seems unlikely that Dr. Einstein said that, the sentiment is correct. Time and compounding market returns are your retirement account’s best friends. While it is possible to take money out of your 401(k) before you retire, this is not a decision to be made lightly. However, for many Americans, their 401(k) represents a significant portion of their personal wealth, and certain circumstances may dictate that tapping into that asset is the best, or only, financial choice.
Most 401(k) plans allow pre-retirement access to funds by way of loans and withdrawals. Generally speaking, if you must take money out, a loan is the better option. With a 401(k) loan you are, in essence, borrowing money from yourself. You are generally allowed to borrow up to 50% (with a maximum of $50,000) and have five years to repay the loan. The loan is repaid back to the plan with interest. While that interest rate is likely lower than the rate of return the funds would have earned had they remained invested, it’s at least something, and you are able to return the entire principal balance back into your retirement account. This is a big deal. If you take a withdrawal, you will not be able to return that amount later, and you may even be restricted from making contributions for a period.
In addition, the amount you withdraw will be treated as taxable income. The plan administrator will withhold 20% of the amount for income taxes, and if you are under the age of 59 ½ you will also trigger a 10% penalty.
Your plan may allow a “hardship distribution.” Keep in mind that plans are not required to offer this option. The IRS defines a hardship as an unforeseeable emergency, with a distribution permitted “on account of an immediate and heavy financial need of the employee, and the amount must be necessary to satisfy the financial need.” This distribution will be taxed as income and may even be subject to a penalty.
If you must take money from your 401(k), use a loan instead of a withdrawal to avoid taxes and penalties. Here are a few situations that might warrant tapping into your retirement account.
You may be faced with an emergency and not have any other source of cash. (If you do have an emergency fund, use that first.) It is hard to say what might constitute an emergency for any individual. One example might be a need to pay the deductible on your high deductible health care plan.
You may have an urgent cash need, but your poor credit score makes you ineligible for a competitive interest rate on a loan. Most 401(k) loans charge 1 to 2% over the prime rate, which is currently 5%. A loan at 7% is likely better than the rate on an unsecured personal loan. Try not to borrow more than you need and consider what amount you will be comfortable paying back in the next five years. 401(k) loans do have the advantage of not being reported to credit agencies or triggering a credit search. And since you are repaying the loan to yourself, the “interest” you are paying is really just a transfer of funds from one pocket to another.
You might already be saddled with high interest debt that is hampering your long-term financial goals. If you are in pay down debt mode, then you are looking for the cheapest interest rate and the opportunity to get your debt down or paid off as quickly as possible. Be careful here – if you borrow from your retirement plan and fail to repay the loan, your finances will be in even worse shape.
If you plan on leaving your current job in the next five years, you may want to reconsider taking a 401(k) loan. Whether you leave voluntarily or not, you may have to repay the balance of the loan to avoid having that amount considered a taxable distribution. The new tax law extended the time to repay the balance of the loan from 60 days to October of the following year.
Just because you have borrowed from yourself, do not ignore your debt to income ratio. The classic rule of thumb is that no more than 36% of your gross monthly income should go toward servicing debt. You should treat your plan loan as you would any other extension of credit.
Your retirement plan will have its own rules for loans. They may limit the number of loans available, and the amount that is available for you to borrow. Your plan can also establish their own repayment schedules, which you will need to follow. Remember that the loan payments will come out of your paycheck, reducing your take home pay.
If you or your spouse take a loan from a 401(k), and you get divorced while the loan is still active, be sure that your Decree of Divorce properly accounts for the loan. A Qualified Domestic Relations Order (QDRO) will need to be prepared based on information taken from the Decree, in order to divide the asset. If this is incorrectly worded, you may get stuck with the entirety of the loan, or the account may be divided in a manner which treats the loan as an asset not a liability. Make sure you have an attorney with experience in QDRO preparation draft the QDRO to ensure that your intentions are accurately reflected.