If you're facing a temporary financial problem, think twice before taking money from your 401(k). Early distributions trigger a 10 percent early withdrawal penalty and you have to pay income tax on the cash. Even a 401(k) loan can be unexpectedly costly if you lose your job for any reason -- including getting fired. When that happens, you have to pay off the loan immediately. This can result in the unpaid balance being treated as an early withdrawal.
Borrowing From Your 401(k)
Many 401(k)s offer loans, but it's not a requirement. Your Summary Plan Description tells you the loan availability of your specific plan. Usually, you can borrow up to 50 percent of your vested account balance to a limit of $50,000. However, your plan may have restrictions on the reasons you can borrow the funds, including paying for the education of you, your spouse or children, avoiding eviction from your home, taking care of unreimbursed medical bills, or buying a home for the first time.
Paying It Back
Typically, you have five years to pay back the loan unless you use it to buy a first-time residence. Then, you can get an extended payment period. Loan payments get deducted from your paychecks and some plans don't allow you to make contributions during the repayment period. Also, your spouse may have to okay the loan. If you pay back the loan, the loan doesn't get taxed or incur a 10 percent early withdrawal penalty.
Losing Your Job
Here's the risk: If you're fired or lose your job, you have to pay back the loan immediately. Typically, the remaining balance on the loan is taken as a distribution to pay the outstanding balance. Now you have to deal with the tax consequences of the withdrawal -- including the 10 percent penalty and ordinary income taxes in the year of the withdrawal. This can cause a lot of stress, especially on top of having your employment terminated.
You don't have to pay the early withdrawal penalty if you're 59 1/2 or older, but income taxes are still due. If you're younger, consider the future costs of all present 401(k) loans or withdrawals. You lose both the tax-free growth of the loan amount, the compounded interest on your investments, and the cost of additional taxes on your money in the current tax year. This can potentially lead to greater financial problems in the immediate future.
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