Podcast #3 - 401(k) Withdrawals and Loans
Updated: Dec 27, 2020
In this podcast transcript we discuss:
-401(k) withdrawals explained
-Withdrawl limits and special circumstances with COVID
-Associated 401(k) penalties and how it affects your taxes
-How 401(k) loans and how they are paid back
In our next topic we're going to talk about the 401(k) withdrawals and loans limits. Typically the limit is $50,000 to withdraw which is straight money to your account or you take a loan and pay it back. The new stimulus package raised it to $100,000 due to the current Coronavirus situations. When you choose to take this path there are caveats that you must understand.
Now the first one is that when you take a withdrawal, you're going to face a 10% penalty if you're under the age of 59.5 years of age, but there are certain stipulations that allow you to take this money to wave this 10% penalty which are known as hardship distributions. So why don’t you tell the audience what this means.
First off not all plans allow for a hardship distribution so you would actually have to seek out your HR administrator or your plan administrator to see if you can take a hardship; however, if they do there's different stipulations in how you can take that or different reasons that you can take that.
Some of the reasons that you qualify for a 401(k) hardship distribution are unreimbursed medical expenses, purchase of a principal residence or college tuition which includes room-and-board for you or a dependent, payments to prevent eviction or foreclosure, funeral expenses or even certain expenses to pay for repairs on your home.
David Okay there is one more piece to this. If you have a Covid related situation, there is a chance that you could get the penalty fee waived. This fee is 10%. So we need to understand how 401(k) withdrawals work regardless of that fee. So let's do a scenario let's say that you take out $20,000 and it was a withdrawal. That means you're going to take a 10% haircut on that $20,000 or a $2,000 hit; and then there is the second part about it which deals with your tax bracket.
Right! So on top of the 10% that David is talking about you will also get taxed at your normal income tax rate. So you will have double taxation. In the end you're reducing your distribution exponentially and that takes away from your future growth from your retirement.
In this example, we’re talking about $20,000 or the first $2,000 for the 10% penalty. Now, let’s just say that you are in the 20% bracket. This is an example which is somewhat common. Now that's another $4,000.
Right, so that’s another $6,000 right off the top that you're taking away from your retirement, from your 401(k), and again we know that there are hardship situations that actually can't be avoided, but if there's no other option that's when it's allowable under a 401(k). You have to actually provide proof that you've exhausted all other opportunities to take take that money.
There are people out there who take withdrawals and they're not in those situations and so it is very important like Cindy's alluding to, is to make sure that you don't take the money unless you really need it. So for example, what we pointed out in this scenario is that if you took out $20,000 you're only getting $14,000. So really be mindful of this if you are considering taking this option. You can't get this money back.
So there's a second option which is a 401(k) loan and we are proponents of this; only if you're going to have to take money out of your 401(k). So we can take the same scenario and if you take a loan at $20,000 you're going to end up actually paying yourself back with interest.
RIght, and I'll just repeat again not all plans provide for a loan provision so that’s something you would have to reach out to your HR team or your plan administrator to find out if the plan allows for a loan. I oversee about 23, 401(k) plans; they're all different.
Not all plans allow for loans so that's something need to detrmine, but if you do choose to take a loan out, you do have to pay interest meaning you will pay your self-interest back at a prime rate; in addition you need to consider that there's also loan origination fees and potentially other fees tied to this that get deducted from that.
The one thing that I would really urge you to consider is that you may detract from the market-related growth that you'll have during the borrowing period. Secondly, if you do leave your job, terminate your job or get fired from your job, you still owe that loan so you can keep the same loan terms; however, if you default on that at any time then you'll have a 100% taxable loan and/or a taxable distribution to your normal tax rate along with an early withdrawal 10% penalty imposed by the IRS.
So there's a lot to take in there. So if you choose to take a loan, you need to consider what the prime rate is and that’s what Cindy was mentioning. It is a rate that is charged by banks to their most creditworthy customers and as of this recording it's around 3.25%, and then the loan will also cost in the neighborhood of 1- 2% on top of that rate. So if it was today's rates it would be 4.25 - 5.25% to borrow your money. Regardless of what the interest rate calculates to be, it is tacked on top of the loan meaning that you have to pay it back like a typical car loan.
Right! There’s loan terms, so you can pay up to five years on a 401(k) loan. Again we don't want to use it for a savings account; that money really is slated and earmarked for your retirement; that's the whole point of it. When you take that money out you're taking out growth opportunities towards your retirement and we know there's scenarios where you may need to borrow money; however, we really discourage that because you're just taking that money out of the market completely.
So what Cindy is saying about taking this money out of the market means you're taking this money from your plan and it is not being invested in current securities; which most or all of it would be in your mutual funds in your 401(k) or a pre-retirement plan.
So now you can take this money out and even though you're paying interest back to yourself, typically that rate is lower than what you're going to make in the stock market per se. If this happens may miss out on the compound interest opportunities.
I would actually recommend if you're having a hardship maybe just decrease your contribution rate for a time being, and those can fluctuate. I've had to do that in the past where larger things or purchases or something broke down and I needed that cash in my pocket . . . this is going back to having credit card debt and while contributing to your 401(k).
I'd rather see you not contribute as much to your 401(k) to start chunking away at those high interest credit cards. If you do follow that rule of thumb and find a credit card company that you can do the zero interest transfer or 0% balance transfer then that's win-win, but you don't want to be taking a loan and paying high interest credit cards debt or putting that towards even paying the credit cards down because ultimately you're paying yourself back roughly 3-4%; however, at the same time you may be paying be 20-30% in credit card interest. Therefore, that would be very counterintuitive to what you're trying to accomplish for the long term.
So seeing that we talked about credit card interest along with the 401(k) fees we should do a quick recap.
David #1 If you have credit cards, the number one thing that you need to do is to lower your interest rate. So if you have the ability to lower your interest by a credit card balance transfer even with a cost of the balance transfer, that is what you should do first. The result of that is paying less interest each month and you'll pay your credit card down faster. It will also create more disposable income.
If you need to borrow money we talked about a 401(k) loan (or another pre-retirement plan). Taking the loan in this case means that you are going to pay yourself back along with some interest. The disadvantage is that in most cases you won't make as much money as you would if you left it there in the first place in the stock market; in addition, another way to create some more disposable income with the loan, is to stretch out the years that you pay the money back. In most cases it goes up to five years, so the longer the loan term the lower the payment.
For the third scenario, that's the hardship withdrawal. For most people when they do this, they are in dire straits meaning they're willing to take a big sacrifice on their money that they're never going to get back. In our example we said if you took out $20,000 with a 20% federal tax rate, you would only yield $14,000 of that, so that $6,000 will never come back to you.
If this is something you're willing to do please take your time and make an informed decision. The whole point of all three of these scenarios is you need to reduce the amount of money that you're going to pay out, so keep in mind as we talked about in our first podcast, is to find ways to reduce your monthly bills.
So that means if you have to stop ordering food delivery, buying coffee, reducing your cable bill or your phone bill or using rags instead of paper towels . . . it doesn't matter how big or how small the items are because the more that you save, the less you're going to need to borrow especially in the case of the withdrawal scenario.
If you're in this situation, take your time and make an informed decision. Open up a spreadsheet or get a piece of paper and start mapping out all the scenarios. What it's going to cost you and how much are you going to save . . . how much are your payments going to be each month . . . and that way you can lay out the groundwork for the next 12-24 months, or how many months that it will take to get back on your feet, or pay down your debt. The last thing that you want to do is have regrets because you made a hasty decision.
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