New Rules for Borrowing Money from Your 401k and Other Options to Consider

New Rules for Borrowing Money from Your 401k and Other Options to Consider

The COVID-19 pandemic has caused millions of people to lose their jobs or temporarily stop earning an income. The halt in cash flow means you can’t afford essentials, such as making home payments and buying food.  Need help filing your taxes? Book an online appointment

If there were no global pandemic, experts would be singing in unison to avoid borrowing money from your 401(k) or 403(b). But desperation and hardship are very real for millions of Americans. If you have emptied your emergency fund and your checking and savings accounts are exhausted, taking a 401 (k) loan to cover current costs may be your next best alternative.  

July 15 tax filing deadline: What you need to know

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Here’s what you need to know about 401(k) loans and taking out money from your retirement accounts before you retire. 

What is a 401(k) loan? 

A 401(k) loan is a loan you take out from your workplace retirement plan. You’re borrowing money from your future self. You’ll still get charged interest on the loan, and loan fees can apply, but the main balance comes from your account. 

Terms for 401(k) loans can vary based on what your plan allows, but in most cases, borrowers are given up to five years to put the money (plus interest) back into the account. If you don’t repay your loan on time, the outstanding balance is treated as a distribution. That means you’ll owe income taxes and must pay a 10% early withdrawal penalty. 

Pre-coronavirus, you could borrow upwards of $50,000 from your 401(k), or 50% of your vested account balance, whichever was lower. (See the standard IRS rules on hardships, early withdrawals, and loans.) But with the CARES Act, that rule and others have changed. 

How the coronavirus changed 401(k) loans 

The CARES Act that was signed into law last month doubles the amount you can borrow from your 401(k) or 403(b) to $100,000, or up to 100% of your account, whichever is lower. 

Borrowers also can defer loan payments for a year. So, you have six years (instead of the previous five) to pay back your loan. The extra year for repaying the loan also applies to existing loans but check with your plan administrator before you delay any repayments.  

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Note that interest will still accrue during this time. But… you won’t owe income tax out the amount you borrowed if you pay it back within the loan period. 

What is a 401(k) withdrawal? 

A 401(k) withdrawal is, like it sounds, when you cash out a portion of the money in your account without the intent of replenishing the account. Pre-CARES Act rules state that you’re required to pay a 10% early withdrawal penalty (if you’re under age 59 ½ at the time of the withdrawal) on top of the federal and state income taxes.  

Under the CARES Act, 401(k) withdrawal rules have changed. The 10% early withdrawal penalty is being waived on hardship distributions. And you have three years to pay any taxes you incur from the withdrawal (instead of owing it for the tax year when you made the withdrawal). Also, if you replenish your account within three years the CARES Act allows you to recover the taxes you paid on the early 401(k) withdrawal. 

All that said, if you want to withdraw money from a retirement account, your best choice is to tap your Roth IRA for cash first.  

The drawbacks of taking out a 401(k) loan 

On a normal day in a normal market, borrowing from your future self wouldn’t be a clever idea. Here’s why: 

• You never get that money back. Even when you repay your loan, the money that would’ve been there the entire time doesn’t get a chance to earn and grow. You lose income by taking money out early. 
• You might need to pay it off sooner. If you leave your job (or lose it), you’ll need to repay your loan by the upcoming tax deadline. So, if you took out a 401 (k) loan right now and lost your job next month, you’d be on the hook to pay it by the July 15 deadline.  
• Repayment is with after-tax dollars. That means when you pull the money back on the road, it’ll be taxed again. 
• You could get taxed anyway. If something comes up and you can’t pay your loan back, it’s considered an early distribution and you’ll face the 10% penalty. 

Alternatives to taking out a 401(k) loan 

If you don’t know about using a 401 (k) loan, think about other ways to get money for the time being. 

• Stopping 401(k) contributions. Instead of continuing to stash that money away, pause contributions so you can pocket more of your cash right now. 
• Take a hardship distribution from your 401(k). The CARES Act waives the 10% penalty for hardship distributions, which means if you are younger than 59 ½, you can take money out of your retirement without facing the extra tax charge. 
• Take out a different type of loan. A personal loan doesn’t borrow from your future self and doesn’t require any collateral. A home equity loan or line of credit (HELOC) might get you a lower interest rate and longer repayment terms, but you’d be borrowing against your home, like a second mortgage. Even so, this might be an easier or less expensive way to borrow money quickly. 

Do the new rules apply to you? 

Before you make any moves, you’ll have to find out if your employer has adopted the new relaxed CARES Act provisions in your 401(k) or 403(b) plans. (If not, inquire about existing 401(k) loan rules.) Some plans also limit the number of loans a participant has outstanding at one time. Employers can change the rules at their discretion. 

Borrowers also must show that they qualify for loans under the new rules. That means that you or a member of your family is diagnosed with Covid-19 and/or are experiencing financial hardships (e.g. Lack of work or reduced hours or salary or childcare closures) linked to the pandemic. 

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