Borrowing money from a 401(k) is a common strategy used to get through hard times. There are some perks to it, including the fact that you don't need good credit to qualify and that you pay interest to yourself.
Some Americans decide these advantages outweigh the considerable downsides, such as passing up investment gains on the borrowed money. If you've weighed your options during the novel coronavirus crisis and decided that a 401(k) loan is the right choice for you, there are five things you need to know before you borrow, as the rules have changed for 2020.
1. You can borrow up to $100,000 or 100% of your vested balance
Traditionally, 401(k) loans were limited to the lesser of $50,000 or 50% of your vested balance.
The CARES Act doubled the amount you can take out of your retirement accounts, so you can borrow up to $100,000 or 100% of the amount of your vested balance. Of course, you can only borrow as much as you have available in your 401(k). The larger limit applies only for coronavirus-related loans.
The bump in the maximum borrowing amount also applies only to withdrawals made between Jan. 1, 2020, and Dec. 31, 2020.
2. You will have an extra year to repay the loan
Normally, you have to repay a 401(k) loan within five years of borrowing the money from your account. However, the CARES Act extends your repayment time if you're borrowing due to COVID-19.
For loans outstanding after March 27, 2020, with payments due between March 27 and the end of this year, you'll have six years to repay what you owe. That extra year can make repayment more affordable, although it means your money will be out of the stock market for longer, so your loan could be costlier in the end.
3. Not all 401(k) plans will allow you to take this larger amount or even to borrow at all
Although the CARES Act allows employers to enable larger loans, it doesn't require them to. Not all 401(k) plans allow borrowing, and not all plan administrators will opt to enable loans up to the larger amount.
If you hope to borrow against your retirement funds, you'll need to find out if this is even an option by talking with your plan administrator.
4. You may have to repay the money by tax day next year if you lose your job
Departing from your job used to trigger a requirement that you repay your loan within 60 days. However, the rules changed due to a 2018 tax overhaul. You'll now have until tax day for the year you took the withdrawal to pay what you owe.
So if you borrow in 2020 and lose your job, you'll have to repay the full balance of your loan by April 15, 2021 (or Oct. 15, 2021, if you file for an extension on your taxes).
This longer deadline slightly reduces the risks of borrowing. But if you take out a loan now, spend the money, and then are faced with an unexpected job loss, it could be hard to repay your loan in full -- especially if you took advantage of the new larger loan limits and owe a lot.
5. Your loan will not convert to a penalty-free withdrawal if you default
The CARES Act not only changed the rules for 401(k) loans, but it also altered them for withdrawals. In fact, you're allowed to take a coronavirus-related distribution from your 401(k) in 2020 without incurring the 10% tax penalty normally associated with early withdrawal before age 59 1/2.
Unfortunately, if you default on your 401(k) loan, it doesn't convert to a penalty-free withdrawal, even if you would have been entitled to one this year. The defaulted loan is considered a withdrawal or distribution and thus subject to that 10% penalty. That's a huge cost to bear, especially when you also consider the loss of the potential gains your money would have made had you left it invested.
Weigh the pros and cons before you take out a 401(k) loan
Keep these special rules in mind when you decide how much to borrow, or if you should borrow at all. Because the CARES Act also changed the rules for 401(k) withdrawals, you may want to consider whether that might be a better option for your circumstances.
Once you've assessed your situation, made sure you're comfortable with the payback process, and considered the downside risk of raiding your retirement plan, you can decide what's best for you.