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Should I Take a 401(k) Loan or a Withdrawal?

By Kailey Hagen – May 15, 2020 at 9:02AM

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There are new rules for 401(k) loans and withdrawals. Here's how to know which is right for you.

The extended job loss due to COVID-19 has left people scrambling to figure out how they're going to make ends meet until life returns to normal. The federal government has offered assistance in the form of stimulus checks and expanded unemployment, but that's not enough for everyone to cover their expenses. So some of those in need are turning toward their retirement savings.

The CARES Act has loosened restrictions on 401(k) loans and withdrawals, but you should still use these as a last resort. Taking money out of your retirement account, whether temporarily or permanently, can set you back and make saving enough for retirement an even bigger challenge. But if you've exhausted all your other options, using your 401(k) funds may be smarter than taking on debt. Here's what you need to know about 401(k) loans and withdrawals under the CARES Act to decide which is right for you.

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Image source: Getty Images.

401(k) loans

401(k) loans existed before the pandemic, though not all plans allow them. Under the old rules, you could withdraw up to 50% of your vested balance or $50,000, whichever is less. The CARES Act doubled these limits, so you can now borrow up to the lesser of $100,000 or 100% of your vested balance. 

Just like a regular loan, you pay back what you borrowed plus interest, but the advantage here is the interest goes toward your retirement, rather than lining a banker's pocket. You typically have up to five years to pay back what you borrow, and if you fail to do so, the outstanding amount is considered a distribution and taxed accordingly. You'll also have to pay an early withdrawal penalty if you're under 59 1/2. But if you put all the money back in time, you won't owe taxes on it until you withdraw the money in retirement.

Some 401(k)s still aren't allowing loans, even amid the pandemic, so you'll have to talk to your plan administrator to see if this is an option for you. A loan will give you more time to pay back the money you took out before you must pay taxes on it, but it may not be your most flexible option right now given the changes the CARES Act has made to 401(k) withdrawals.

401(k) withdrawals

A 401(k) withdrawal is where you take the money out of your account without any obligation to pay it back. Normally, you pay income taxes on your withdrawals in the year you make them, unless the money comes from a Roth 401(k), and you'll pay a 10% early withdrawal penalty if you're under 59 1/2.

The CARES Act has done away with the early withdrawal penalty for withdrawals up to $100,000 during the pandemic and it enables you to spread your tax liability out over three years. So if you withdraw $9,000 from your 401(k), you can pay taxes on $3,000 this year, another $3,000 the next year, and the final $3,000 the year after, instead of having to pay taxes on all $9,000 this year. That can keep you from ending up with a tax bill that's a lot larger than you anticipated and it may also help to keep you in your current tax bracket, so you don't lose a larger percentage of your income to the government.

The new law also enables you to pay back any money you took out within three years, and if you do so, these contributions won't count toward your annual 401(k) contribution limit for the year. They'll be treated as rollovers. So if we use our example above, you'd be able to contribute an extra $9,000 over the next three years on top of the annual contribution limit to your 401(k) if you choose. But not all 401(k)s allow rollovers and in that case, you may not be able to put back what you borrowed. 

If your plan does allow them, you can file amended tax returns for the previous years after you've put the borrowed money back and the federal government will reimburse you for the taxes you paid on your 401(k) withdrawal during those years.

Which option is best for me?

401(k) withdrawals are usually worse than loans, but in the current climate, they're actually the better choice for most people. You have to start paying taxes on your distributions this year, but you can spread the tax liability out over three years, and you have the option to put back what you borrowed. If you're able to do that, you can request that the federal government reimburse you for the taxes you've already paid, and then it's sort of like taking out a loan.

Consider how much money you're making this year and which tax bracket you expect to fall into to decide if it makes more sense to pay your taxes all at once or to spread them out over three years. If you're earning a lot less than normal, you might be in a lower tax bracket than you're used to, even with your 401(k) withdrawal. In that case, it might be smarter to pay all of your taxes this year rather than spreading them out and potentially giving a larger percentage of that money back to the government in future years when your earnings are higher again. 

A 401(k) loan may still be an option for you if your plan allows loans and you don't want to worry about any tax liability this year. But you're taking a bigger risk. If you're unable to pay your loan back within the five-year time frame, you'll owe taxes on the outstanding amount plus a 10% early withdrawal penalty. That could lead to a bigger tax bill and set your retirement savings back even further.

It's smart to compare both options, but a withdrawal may make the most sense in the current situation. Aim to pay the funds back once you return to work if you're able to so you can recoup what you paid in taxes and minimize the effect the withdrawal has upon the growth of your savings.

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