Emergencies happen, and while accountants recommend having a savings or emergency fund to draw on in the face of unexpected expenses, individuals may also turn to their 401(k) when their finances fall short. While unideal, using 401(k) funds may be smarter than taking on debt. However, with different rules surrounding 401(k) loans versus withdrawals, deciding which option to choose can be challenging. Use the guide below to explore the benefits and disadvantages of each to determine which is right for you.
When you take out a 401(k) loan, you're borrowing money from your retirement account to help pay for urgent expenses. The loan cannot exceed $50,000, or 50% of the vested account balance—whichever is less. You're required to repay the loan, plus interest, in full, within five years. However, unlike a traditional loan, any interest paid goes toward your retirement fund, rather than administration fees.
401(k) loans are ideal for individuals facing short-term financial setbacks. Since you're borrowing from yourself, the loan doesn't typically require a credit check. Because the IRS doesn't view it as income, 401(k) loans are tax-free, as well.
While a 401(k) loan is beneficial for some, it may not be right for everyone. The short repayment term might make it difficult for those facing extreme hardships to pay it back on time. If you fail to repay on time, the outstanding balance is taxed, and you'll be required to pay an early withdrawal penalty if you're under the age of 59.
401(k) withdrawals allow you to take money directly from your retirement savings without any obligation to put it back. A withdrawal is an ideal choice for individuals facing long-term hardships and financial uncertainties.
Typically, the IRS requires you to pay income taxes and a 10% penalty on early withdrawals, unless the money comes from a Roth 401(k). However, the CARES Act has temporarily suspended this penalty during the coronavirus pandemic and has enabled individuals to spread their tax liability out over three years. This helps keep you in a lower tax bracket and reduces any immediate tax debts.
While beneficial to those facing hardships, 401(k) withdrawals can also be used for nonemergent situations, such as college tuition and expenses, or as the down payment on your first home. In these circumstances, you can make a withdrawal on your 401(k) without paying penalties. However, it is recommended you work with an accountant to discuss each situation before tapping into retirement funds.
If you're considering a 401(k) loan or withdrawal, the professionals at Demshar Eaton CPA in Ashtabula, OH, can help. With over 20 years of experience, these trusted accountants will work with you to map out your finances and help you make the right decision for your unique situation. Call (440) 992-6622 to schedule an appointment or learn more about their services.