Per a report by the Federal Reserve, it’s estimated that about 40 percent of all Americans wouldn’t be able to afford an unexpected $400 surprise expense. Noting this, it would be a safe assumption that the number of Americans who wouldn’t be able to afford an expense that’s greater than $400 would be much, much higher.
Things happen, it’s a fact of life. Whether it’s a surprise medical emergency, household repair, auto repair bill or something else, there’s bound to be a number of unexpected expenses that all Americans will encounter at times throughout their lifetimes. And while every American should have some sort of a savings or rainy-day account (experts recommend putting aside at least three months’ worth of expenses into a savings account), this isn’t always the case.
Hence, when things get tricky financially and there’s no savings account to fall back on, people have to come up with a Plan B. Borrowing money from a friend or relative, taking out a bank loan or using a credit card (if applicable) are all viable alternatives. So, is borrowing money from your retirement savings, something that many Americans are turning to in the event of a true financial emergency. We thought we’d take a closer look at this practice, and what you need to know about borrowing from your 401K.
Borrowing from your 401K 101
First of all, it’s worth noting that if you don’t have to borrow from your 401K, we’d strongly advise you not to do it. That’s because when you withdraw money, it’s no longer active in the market, where it’s — ideally — growing. Secondly, like any loan, you’ll still have to pay the amount you withdrew from your 401K back — and if you don’t in a certain timeframe, the penalties can be steep.
Here are the basic parameters on taking a loan from your 401K:
- You can only withdraw up to 50 percent of your vested earnings or $50,000.
- The loan must be fully repaid within five years.
- The good news about taking a 401K loan is that they’re generally tax-free, though you will have to repay the loan with interest.
You can also withdraw money from your 401K, though there are generally more strings attached. First of all, withdrawals are subject to a 20 percent withholding fee. And if you’re under 59-and-a-half years in age, you’re looking at an additional 10 percent tax penalty. But any withdrawal that you make, after the required fees and taxes, does not have to be repaid.
The final option you have with securing funds from your 401K is to qualify for a hardship distribution. Not all 401K plans permit this option, but those that do allow you to withdraw money if the reason is due to “immediate and heavy” financial needs. Per the IRS, things like medical care, funeral expenses and payments to prevent home eviction are the sort of things that would qualify for a hardship distribution. You don’t have to repay your plan when you take a hardship distribution, however it is worth noting that any sum of money you take counts toward your annual gross income and is likely subject to standard end-of-year taxes.
It’s usually best not to borrow (or take) from your 401K unless you’ve exhausted all of your other options. And if you do borrow from your 401K, make darn sure that you’re able to repay it in full within the timeframe you’re required to. Remember, a retirement savings is a big part of your financial future, and any money that you have invested in it is maturing and ideally earning money for you in the market. Eliminate any of that — even for only a certain period of time — and you’ll be worse off for it in the long run.
So, beef up those savings and rainy-day accounts to use in the event of an emergency so that your 401K can work for you and your future.