Getting hit with a cash crunch is stressful. What should you do if you need quick access to cash? For many of us who have been working and saving in our 401(k)s, that pot of money can be very tempting. Let’s be honest - 401(k) loans can be relatively cheap and easy to get. They’re kind of like the fast food version of loans. And just like fast food, 401(k) loans can seem like a good idea at first, but they can quickly lead to heartburn.
What you really need to know: there are some serious risks involved with tapping a 401(k).
There are two major risks you need to watch out for: loans that aren’t handled properly (known as deemed distributions) and quitting your job or getting fired - what’s known as “separation from service.”
What happens if you miss a couple of 401(k) loan payments?
Let’s say you are involved in a car accident that leads to significant medical bills and time away from work, so you borrow from your 401(k) to help cover those costs. You also need to buy a new car, which leads to a car loan payment. Now you are trying to make the 401(k) loan payment along with your mortgage and new car loan payment, and it’s pretty tight.
You think - it’s no big deal if I miss a couple of payments, I’m “borrowing from myself” so I can decide to skip a payment, or two, or three.
The IRS does not agree.
If you miss a quarterly payment on March 31st you have a “cure period”, or 3 month grace period, to make that payment. However, if you miss your June 30th payment as well, the IRS will be knocking on your door next tax year. In the eyes of the IRS your loan has turned into a distribution, with taxes owed and potentially a 10% early distribution penalty if you are under age 59.5.
Let’s run that out real quick:
$20K loan turns into a $20k deemed distribution
25% marginal tax bracket = $4,000 in Federal income tax
10% early withdrawal penalty = $2,000
Total due: $6,000
Most employers allow you to sign up to have your loan payments automatically deducted from your paycheck. While I am not crazy about borrowing from a 401(k), if you do take a loan from your 401(k), set up an automatic payment plan.
You get your dream job offer and you have a 401(k) loan
Great news! You just got a call from a recruiter and you’ve been offered your dream job! You sail into your boss’ office give your two weeks and type up a witty resignation letter to send to your co-workers who you not-so-secretly dislike.
One tiiiiiinnnnyyyy little problem. You took out a $30k loan from your 401(k) plan last year to replace your car that was wrecked and you don’t have the cash on hand to pay it off.
Why does this matter if your new employer offers a 401(k) plan? A couple of arcane rules come into play here:
- After you leave your employer you typically have 60-90 days to pay off your 401(k) loan.
- Your new employer may not let you participate in their 401(k) plan until you have worked for 2 months, 6 months or even longer. That’s a bummer.
- Many employers will not accept a 401(k) loan from another employer because they do not want to deal with the administrative headache of allowing 401(k) loans.
- You could roll your 401(k) into an IRA, but you can’t borrow from an IRA so you still have to pay off the 401(k) loan or it turns into the dreaded deemed distribution.
- Some plans allow a rollover from your old employer’s plan plus a transfer of your loan balance. You can always ask your new employer if they will accept a transfer of your loan into their plan, and allow you to continue to make payments through payroll deduction.
(Refresher: Deemed distributions occur when the IRS decides that you didn’t actually take out a proper loan, but instead just made a withdrawal which is taxable (at your highest income tax bracket). On top of that, if you are under age 59.5 you get an additional 10% penalty. Deemed distributions also put a serious crimp in your future retirement spending. Check out this simple calculator from Bankrate to see what it might mean for the future you.)
This can inadvertently put a major crimp in your career trajectory. Not only that, but for most young professionals, your ability to earn money is likely your greatest asset. So now you are stuck in your job and you aren’t earning as much money as you could because of your 401(k) loan.
401(k) loans can be tricky
Tapping into your 401(k) should be a last resort. You might hear someone confidently tell you how easy it was to borrow from your 401(k), but odds are high they have little understanding of what the risks are to that strategy.
It’s possible to get tripped up on payments and end up with a deemed distribution. It can also hamper your career if you can’t hop jobs because you took out a 401(k) loan and can’t pay it off. Or, in a really ugly scenario - add insult to injury should you lose your job with a 401(k) loan outstanding you could be looking at a large tax bill next April.
Some alternatives to 401(k) loans include your own cash savings. If you don’t have the cash on hand you may be able to use a Home Equity Line of Credit (if you have one set up) or get some other sort of personal loan. I feel compelled to tell you something you probably already know but just in case:
Banks don’t really like lending money to people who are cash strapped.
So if we're being honest here, getting a personal loan is tricky. Getting a Home Equity Line of Credit during a crash crunch is also going to be difficult.
It may seem like I say this a lot but it’s only because I truly believe it - if you want to be the master of your own destiny, make sure you have plenty of cash (at least 3-6 months of spending) in an FDIC-insured account. 401(k) loans have their place but you need to be aware of the risks they pose to your career prospects and to your finances.
Can't get enough? Check out these other articles to help you master your money!