It can be frustrating and often frightening when due to unemployment, a recession, or other factors, a person’s available cash is not enough to meet his or her obligations. Sometimes when this happens, a person does have money in his or her 401k plan that could help the person pay his or her bills. However, it is important to understand the potential penalties for borrowing or withdrawing funds from a 401k plan before it is done.
Borrowing from Your 401k Plan
In order to borrow money from your 401k plan, the plan must explicitly allow it. If the plan allows a plan holder to borrow money from the plan then the plan holder may qualify to take a loan of up to 50% of the plan’s assets with a maximum of $50,000. If the borrower makes substantially level payments over the life of the loan and the loan does not exceed 5 years then the IRS will not impose the traditional 10% tax for early withdrawals on the borrowed money.
However, just because the loan can be repaid without penalty does not necessarily make it a smart financial move even in difficult financial times. Plan holders need to think very carefully about all of the risks and all of the costs associated with a loan. For example, some employers are now offering 401k debit cards that allow plan holders to easily access the money in their 401k accounts. Plan holders should be aware, however, that using a 401k debit card is not the same as using a debit card that is linked to your checking account.
A 401k debit card requires you to pay fees and interest on the money that you borrow. That means that you will need to repay more money then you actually borrow in order to replenish your 401k account. If you fail to replenish your 401k account within the 5 year time limit then you will owe income tax on the money borrowed plus incur a 10% penalty if you are not at least age 59 ½.
Early Withdrawals from a 401k Plan
401k holders should also consider whether they qualify for an early withdrawal from their 401k plan. While unqualified early withdrawals are subject to a 10% tax, a 401k holder who meets one of the criteria described below may be able to withdraw the money without paying the 10% tax and without having to repay the money as is required when the 401k holder borrowers money from his or her 401k plan.
An investor may be able to avoid the typical 10 percent tax for early withdrawals if:
- The employee dies and his or her beneficiary seeks to withdraw the money;
- The employee becomes completely and permanently disabled;
- The employee is at least age 55 and no longer works for the employer associated with the 401k plan;
- A qualified domestic relations order (QDRO) is issued by a court that requires that the assets in a 401k plan be split between two divorcing spouses;
- The employee has medical expenses that are greater than 7.5% of his or her income and needs the money in his or her 401k plan to pay the medical bills.
The purpose of a 401k plan is to save for retirement. If funds are borrowed or withdrawn prior to that time then your loan or withdrawal must meet the standards set forth by the IRS and by your individual 401k plan in order to avoid expensive penalties. Therefore, each loan or withdrawal should be very carefully considered.