The Options and Though Process of a 401(K) Loan

So what do to if you get in a cash crunch - you haven't retired - and the majority of your assets are tied up in your 401(k)?  And to top it off - taking a hardship withdrawal is a hassle... your plan administrator is giving you the run-around... and you are under the age of 60?  That was the question that we recently got.

Question posed:

"I am in a real financial pickle, I do not own assets so getting a loan would be impossible.  I am dissatisfied with the lacking options my plan provides.  I am young enough to rebuild my 401k at a later date, but for now, I am willing to take the penalties so I can pay off several debts I have.  I am unwilling to file for bankruptcy at this point.  While I can get a hardship withdrawal, the amount isn't enough, and I need too much documentation and would not be able to get it in the amount I need?"

Here was our answer:

I'm sorry to hear about your pickle; situations like this are always tough but I believe you are doing a good thing by thinking the options through so well. I will try to put my answer within the context of an overall retirement planning environment.

First, let's look at what options exist with a 401k if you are under age 59 and 1/2. The reason age 59 and 1/2 is important is that is the age at which you can make withdrawals from your 401k with no 10% early withdrawal penalty (income taxes still apply) IF your plan allows it. Not all plans do, but many do. Since you indicate that you are under 60, I'll assume that you are also under age 59 and 1/2.

At age 55, IF you are no longer employed by that employer - but you have left your 401k there (ie - you did NOT roll it to an IRA) then you can generally make withdrawals from that 401k with no 10% early withdrawal penalty. This is an important retirement planning and disability planning note, so if the investment platform is a good one, this feature becomes a good argument for NOT rolling a 401k to an IRA - since it allows an extra 4 and 1/2 years of retirement income flexibility. Many financial advisors either do not know this, or choose to ignore it when giving rollover advice. On the other hand, if the 401k investments are poor or are overly expensive, then it might make sense to perform a direct rollover to an IRA from the 4010k when you leave that job. You already said that the 401k hardship withdrawal that you can get is not enough and is a hassle, so I'll skip that one.

That leaves the remaining option that may be available - a 401k loan. IF your plan allows it (most of them do) then you can take a LOAN directly from your 401k. You must pay YOURSELF a reasonable amount of interest and pay the loan back on a regular schedule. Usually this schedule is an automated schedule and deducted from your paycheck. Typically, if 401k loans are available, then the limit is the lesser of $50,000 or 1/2 of your 401k balance.

One of the benefits of the 401k loan is that it is NOT taxable income, unlike a 401k withdrawal, so you save the tax that you would otherwise have to pay. Additionally - if you are in a real cash flow crunch - you can suspend your 401k contributions and only make loan repayments - you do not have to continue elective contributions to your 401k. However, if you leave that employer, the loan is changed to a withdrawal, and the 10% early withdrawal penalty - as well as the income taxes - are due in that tax year.

Good luck with figuring out your pickle. But remember - once you have made it through this challenge, you will have a good bit of experience to fall back on to make you more financially savvy. Unfortunately, financial "savvy" usually is the result of "experience," otherwise known as pain. But once those retirement planning challenges have been faced - then the result is usually a more disciplined and effective investor.

Jon Castle, MSFS, CFP