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Thinking of Borrowing from your 401k? First ~ Know the Rules!

In these lean times, your savings account may be decreasing and you may need some extra cash. Loans are hard to come by with banks and lending institutions.  Borrowing money from friends and family may not be an option for you. Your retirement funds are nestled away in your 401k plan but it’s always been advised that you don’t touch it unless it’s a hardship.

If you are still working, your company may have some restrictions about borrowing or withdrawing from it, and if you are retiring or retired, your options will differ. The following are standard options for you if you are still working: There are usually two ways to withdraw from your 401K.

You can withdraw money as [1] a loan to yourself or you can withdraw money by [2] claiming a hardship.

[1] Withdrawing monies as a LOAN.   You are ‘borrowing’ on your own money according to the rules of your plan and pay yourself back with interest (usually the going prime rate plus 1%). You can take up to five years to repay the amount borrowed. In a loan to yourself, there are no restrictions on why you are withdrawing: it could be a large personal purchase, wedding expenses, a new car or anything you may want to buy. There are no tax penalties involved in this type of withdrawal. Repayment of loans are taken out automatically from your payroll check. You may repay back the entire amount of the loan without any penalties. Some 401k plans require a spouse’s approval for any loan amount.

Disadvantages of Loan Withdrawal:

[a] the money you withdraw will hamper your retirement funds with the loss of five years of compound interest – the “golden egg” of 401ks. Compound interest charts will give you an idea of what you may be giving up by losing all the compounding interest that you could have earned, therefore diminishing your future earnings.

[b] If you leave the company or are terminated before the loan is paid off then you have to repay the loan upon your termination or it will be considered as an ‘early withdrawal’ and the penalties that come with it — plus taxes.

We all know that there are life events that could force you to withdraw from your 401k if there are no other financial sources, such as a home equity loan. The only other way to withdraw on your 401k is to claim a ‘hardship’.

[2] Withdrawing monies as a HARDSHIP.   Hardships are defined as : overdue medical expenses; avoiding foreclosure (stipulations vary), funeral expenses, and college tuition. These hardships require documentation to prove that you have no other assets to draw on before the hardship is allowed.

Disadvantages of Hardship Withdrawal:

[a] Not only will you pay income taxes on the withdrawal amount (as added income), but also a 10% federal penalty for early withdrawal.

[b] You will be suspended from contributing into your account for six months, losing any company matching funds; a big loss that is hard to recoup, again, by losing all the compounding interest that you could have earned, therefore diminishing your future earnings.

[c] If your employer goes bankrupt or you’re laid off, the loan automatically becomes due. You will be given a certain amount of time to pay it back. If you fail to do, you will be classified as “default.” If you are on default for a 401k loan, you will be charged a 10% penalty fee for the outstanding loan amount as well as pay federal and local state taxes.

These withdrawal options above are for when you are still working on the job. It is advised by financial planners that when you leave your company or retire, you should roll your 401k into an IRA or other stable or fixed fund investments.

Disclaimer:  These materials have been prepared for information purposes only. They are not intended to be nor do they constitute legal advice.

Marie Coppola © Revised November 2012