September 17, 2020
By Rahul Iyer
401K plans should fund your retirement and in a perfect world, you don’t touch the funds until you’re at least 59 ½. Unfortunately, none of us live in a perfect world. Life happens and financial needs arise – just look at COVID-19 and how it affected millions of people’s financial security.
So what should you do when disaster strikes and you need money now? If you’ve tapped all other financial resources, you have two options to tap into your 401K – a 401K loan or 401K hardship withdrawal.
Which is better?
The name says it all. You borrow from your 401K. Only this time, when you repay the funds (and interest), you pay yourself, not a financial institution. Not all employers allow 401K loans, so check with your employer first.
Most employers allow loans up to the lesser of $50,000 or 50% of your vested balance. Some employers increased this amount after the CARES Act passed and legally enabled providers to increase loan allowances.
How it Works:
You borrow the funds tax and penalty-free
You pay the funds back with interest within 5 years
There’s no credit check or ‘qualifying’
If you leave your job, you may owe the entire amount back within 30 – 60 days
A 401K hardship withdrawal is a withdrawal – you don’t pay the funds back, or at least aren’t under the obligation to do so.
Under normal circumstances, you pay a 10 percent penalty fee plus applicable taxes according to your current tax bracket. The CARES Act changed things slightly – you don’t owe the 10 percent penalty and you can divvy up your tax liability over 3 years. This only applies to those affected by COVID-19, whether physically or financially.
The CARES Act also allows (not requires) you to pay back the funds you withdrew within 3 years. If you do, it doesn’t count toward your maximum 401K contribution allowance ($19,500 in 2020).
If you don’t qualify for the CARES Act withdrawal, you may qualify for a hardship withdrawal if you are facing a financial issue, such as foreclosure, high medical expenses, or you need money for college.
How it Works:
You withdraw the funds up to your allowable limit
Pay the applicable taxes
Deduct 10 percent of the withdrawal (if you don’t qualify for a CARES Act withdrawal)
Only use a hardship withdrawal if you’ve exhausted all other options and need the funds. If you’re going to lose your house, for example, it’s a no-brainer. But if the funds are for college or even to pay medical expenses, you may find other options including financial aid.
A 401K loan isn’t the end of the world, but it does reduce your compound earnings. If you’re using the funds for something productive, such as paying off high-interest debt or renovating your home and you’ll see a return on your investment, then it may make sense. Just make sure you can repay the funds within 5 years.