You already know you shouldn’t tap your retirement plan to fund frivolous purchases, yet in a handful of cases it just might be okay to take a loan. Retirement plans account for a large chunk of personal wealth and in order to get the most out of your retirement plan, you should let the money accumulate over the course of your career. But, sometimes, emergencies will call for the more drastic step of taking a plan loan. Here’s how to borrow from your 401(k) without ending up with a big tax bill.
Depending on whether your plan permits borrowing, you’re generally allowed to take up to 50 percent of your vested account balance to a max of $50,000, whichever is less. You have five years to repay the loan.
Your plan administrator will withhold 20 percent of the amount to cover income taxes and you’ll trigger a 10 percent penalty if you’re under age 59½.
A hardship distribution is what happens when an employee pulls his or her own contributions to cover what the IRS describes as an “unforeseeable emergency.” These distributions are included in your gross annual income and may be subject to additional taxes, but they aren’t repaid to the plan. This means they permanently lower your account balance at work.
When you can borrow
Once you pull money out of your plan, those dollars no longer benefit from long-term market returns. If you have a pool of emergency funds, it’s best to use that money first. If you’re managing debt, it’s even better to build that repayment into your budget.
That said, here are three extreme cases that may warrant a 401(k) loan.
1. You have an immediate emergency. Say that you need to meet the deductible on your high-deductible health-care plan, and you have no money in your health savings account.
2. You have an urgent cash need, but your credit precludes you from obtaining a competitive interest rate.
3. You need to pay off high-interest debt that’s hampering your long-term financial goals. This is the case if the interest rate on your 401(k) is lower than what your creditor is offering you.
What not to do
In the worst of scenarios, you’ll borrow from your retirement plan, fail to repay it and end up with your finances in even worse shape. Don’t borrow if you’re planning on leaving. Whether you quit your job or you’re fired, you may need to repay the whole balance of your loan within 60 days or else the amount borrowed is considered a taxable distribution.
Don’t ignore your debt-to-income ratio. Treat your plan loan the way you would any other extension of credit. The classic rule of thumb is that no more than 36 percent of your gross monthly income should go toward servicing debt.
Don’t blow off your plan’s rules for loans. Those actions include limiting the number of loans available or the amount of money that’s eligible for borrowing. Plans can also establish their own repayment and schedules, which you’ll need to follow.