401(k) plans are a great vehicle for saving for retirement. Typically, an employee can choose to allow an employer to contribute a portion of his or her salary to the plan. Some employers might even match those contributions. The 401(k) contributions are invested in funds that might include money-market, mutual, or bond funds.
You are not taxed on 401(k) funds until you withdraw money from your plan. And, while it is your money, there are consequences to withdrawing money from your 401(k) before you reach age 59 and ½.
Penalty-free withdrawals are available if you:
- Become disabled
- Suffer “financial hardship” (determined by your plan’s terms)
- Have an employer who discontinues the existing 401(k) plan but does not create a new type of retirement plan in its place
If you take a withdrawal from your 401(k) without meeting one of the above criterion, your early withdrawal will cost you a 10% excise tax, unless you are 55 or older and no longer work for the company that sponsored the plan, or need the distributions to pay for child support, alimony, or to pay unpaid income tax bills.
In other words, you have a big chunk of money but can’t get to it without paying a heavy cost. Right? Not necessarily.
Some plans allow members to take loans from their 401(k), which they repay with after-tax funds at a predetermined interest rate. The balance of the 401(k) is increased by repayment and the interest.
Not every 401(k) program allows employees to take loans against their plan, but typically, employees with plans that permit it are allowed to borrow up to 50% of the vested balance (up to $50,000) without the money being taxed.
This loan must be repaid within 5 years, with payments submitted at least quarterly. If you default, the money you borrowed is reclassified as a taxable distribution, and you will suffer all the implications of early withdrawal. If you leave your job after taking a loan against your 401(k), you might be obligated to repay the loan balance within 60 days, and the money you borrowed will be considered an early withdrawal, with the 10% excise tax and income-tax ramifications thereof.
One exception: If you use the loan funds from your 401(k) to purchase a primary residence, the repayment period is typically extended.
If you have an IRA account that you can’t borrow money from, but you’re looking to buy a home, build a business, or go back to school, you might receive a better interest rate by rolling your IRA into a new 401(k) plan and borrowing against that.