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Can I borrow money from my 401(k) before retiring?

Some 401(k) plans do not allow employees to borrow against the money they have built up in their account, but many other plans do. According to "Dun & Bradstreet Guide to Your Investments" (HarperCollins Publishers Inc., New York), many plans that permit borrowing allow employees to tap up to half the amount in the account (but never more than $50,000). You pay interest on the loan to your own account, typically a percentage point less than what banks charge on secured personal loans. You must make payments on the loan at least once every quarter. The entire amount usually must be repaid within five years unless the money is used to purchase a principal residence.

Must my spouse agree to a loan from my 401(k) plan?

If you are married and hope to borrow from your 401(k) plan, your spouse’s approval may be required. Your spouse’s approval will certainly be required if your 401(k) plan follows standard joint-and-survivor rules, which means that you and your spouse have the option of receiving your retirement payout in the form of lifetime annuity payments. Your company’s human resources, personnel or benefits department can give you the details.

Is it better to borrow from my 401(k) account rather than make early withdrawals?

In some cases, you can borrow from your 401(k) account rather than making an early withdrawal. Borrowing from your 401(k) is a much better option because it will allow you to escape the stiff taxes and 10% penalty that are levied on early withdrawals. Some 401(k) plans permit borrowing, but others do not. The decision rests solely in the hands of your employer. If your employer permits borrowing, there are other reasons why a loan is much better than an early withdrawal. Instead of costing you money, a 401(k) loan will actually earn money for you because you will repay the money -- to yourself -- along with interest. Borrowing from a 401(k) is also much easier than borrowing from a bank because there are no credit standards to meet. Since you own the money in your 401(k), you automatically qualify for a loan if the plan permits them. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Legally, loans can be allowed for any reason. But most plans permit them only in specific, approved situations, such as if you’re using the money to buy a house or pay for college tuition. Employers have two good reasons for restricting plan loans. One is that loans add to the cost of administering the plan. The other is that allowing loans for any reason can defeat a 401(k) plan’s main purpose, to ensure that you retire with a substantial nest egg."

Is there any drawback to taking a loan from my 401(k) account that I should be aware of?

Probably the biggest pitfall facing a 401(k) borrower is having to pay all the money back in a lump sum in case you quit your job, get laid off or are fired. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Very few plans allow a former employee to continue repaying a 401(k) plan loan. If you leave your job, voluntarily or involuntarily, you’ll almost certainly have to repay the outstanding balance within 60 days -- into the 401(k) plan or into a rollover IRA -- or the IRS will treat it as an early withdrawal on which you owe income taxes and an early withdrawal penalty. If you’ve spent all the money, that puts you in a very tough spot." Paying the money back in a lump sum won’t be a problem if you have lots of money tucked away in savings or if you have other investments that can be sold in order to raise cash. Or, if you own a home, you might be able to borrow against your equity to pay the loan back. But if you can’t find a way to pay the loan off, your problems will be compounded by a big tax bill.

How much of my total 401(k) account can I borrow?

If your employer allows you to borrow from your 401(k), the maximum loan is half of the value of the account. Federal law will limit the amount to the lesser of $50,000 or 50% of the vested balance. Say you have $80,000 in your 401(k) plan. You could borrow up to 50% of the value of the account, which means you could get up to $40,000. However, if your 401(k) plan is worth $100,000 or more, federal law would prohibit you from borrowing more than $50,000 -- even if your account is worth millions. However, some plans impose even lower limits; the plan document may limit the maximum amount for loans and restrict the availability of loans.

What will a loan from my 401(k) plan cost me?

When you borrow money from a 401(k), the Internal Revenue Service requires that you charge yourself a "market rate" for the loan. The market rate is considered the rate you’d pay if you got the loan from a bank instead. Usually, the market rate is one or two percentage points above the prime rate. So, if the prime rate is 7%, the rate on your 401(k) loan should be 8% or 9%. Many 401(k) plans also charge loan-processing and administrative fees that can add up to hundreds of dollars. But borrowing from your 401(k) is still much better than borrowing from a bank, because you’re paying the interest to yourself. Essentially, the loan becomes a fixed-rate investment in your own 401(k). When you retire, you’ll get all the money back, but the interest you pay on the loan with after-tax dollars will be taxed a second time when you withdraw it.

How soon do I have to repay a loan from my 401(k)?

If your 401(k) permits borrowing, you will probably have to repay the loan through a series of regular payments. More than likely, your employer will automatically deduct the payments from your regular paycheck -- much as it automatically deducts your 401(k) contributions. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "The entire amount you borrowed must be repaid within five years with one exception: if you took a loan to buy a principal residence, the law says that it must be repaid in a ’reasonable’ period of time. Most plans give you up to 25 years to pay it back, but the term of the loan can’t extend beyond your normal retirement date, as defined by the plan." The catch is that if you leave your employer, whether voluntarily or involuntarily, you will probably have to pay all the money back in a lump sum within 60 days. That could put you in a tough spot, especially if you have spent all the money.

If my money is divided among several different funds within the 401(k) plan, which one should I borrow from?

Most 401(k) investors have their retirement money spread out over two, three or more investments their plan offers. For example, you might have half your money in a stock mutual fund, one-quarter of it in a guaranteed-investment contract that pays a fixed rate of return and the remainder in your company’s own stock. If you borrow from your 401(k), the company may have rules that dictate which fund you must borrow from. Other plans simply take a proportionate amount from each investment in the account. Still others let you decide which fund you want to tap for the loan. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "From your 401(k) account’s perspective, your loan is a fixed-rate investment. To maintain your current mix of investments, you should borrow the money from a fixed-rate fund. Let’s say that you have $45,000 in your account and it’s currently divided equally between three funds: $15,000 in a diversified stock fund, $15,000 in a corporate bond fund and $15,000 in a guaranteed investment contract (GIC) fund. Of those three investments, only the GIC fund pays a fixed rate of return. So if you want to stay with that investment mix, you’ll reduce the allocation to that fund by the amount of the loan."

Is the interest I pay on a 401(k) loan tax-deductible if I use the money to buy a house?

If you are planning to borrow from your 401(k) and use the proceeds to buy a home, it’s important to remember that the interest you pay on the loan from the account will not be tax-deductible, unless the house itself is used as collateral for the loan. When you borrow from your 401(k), the collateral is actually the remaining balance in your account, unless you specify in the loan agreement that the has shall be collateral for the loan. If not, you can’t deduct the interest you pay back to your 401(k) even if you use the loan proceeds to buy a home. This tax rule might seem unfair, but it actually makes perfect sense. By its very nature, a 401(k) is a tax-deferred investment: Allowing you to deduct interest on loans from the account would amount to giving you one tax break on top of another. Before you borrow from your 401(k), check with a few local lenders to make sure they will accept 401(k) loans as down payments. Many banks won’t make loans to buyers who have had to borrow their down payment, in part because they don’t want another creditor coming forward with a claim on the home. But some lenders make an exception for 401(k) loans because the money comes from your own savings.

Can I use my 401(k) account as collateral for a bank loan?

No. You can’t legally pledge retirement plan assets as collateral, and the vast majority of bankers wouldn’t accept it anyway. Why? Because the money you have socked away in a 401(k) is be protected from creditors under federal law. Lenders understandably don’t want to make a loan based on collateral that they can’t collect.

How do I qualify for a hardship withdrawal from my 401(k)?

Your eligibility for a hardship withdrawal from your 401(k) plan depends on the plan’s rules. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "You’ll probably have to provide relevant information showing your financial need -- an eviction notice, a contract to buy a primary residence, unreimbursed medical bills or a college tuition bill. Some plans require that you sign a form stating that you have no other source of money to deal with this emergency. Other companies instead consider that you’ve exhausted all other resources if:

1) you have taken all permissible loans from the plan;
2) you make no plan contributions for the next 12 months;
3) you make only limited contributions in the year after that; and
4) you withdraw only as much as you need to cover the immediate emergency."

Remember: Even if you qualify for a hardship withdrawal from your 401(k), you will still have to pay a 10% penalty in addition to the normal federal, state and local income taxes.

Is there a limit on how much I can take in a hardship withdrawal from my 401(k)?

If you qualify for a hardship withdrawal from your 401(k), the amount you can take out is usually limited to your own pre-tax contributions that have accumulated in the plan. Within that limit, you will be able to take out whatever amount is necessary to satisfy your financial emergency and cover the taxes that will be owed on the withdrawal. Period. You cannot withdraw a few thousand dollars extra to take a vacation or pay other non-emergency expenses.

Are my employer’s contributions to a 401(k) available to me if I make a hardship withdrawal, or can I only take out my own contributions?

If you are eligible to make a hardship withdrawal from your 401(k) retirement plan, your ability to tap your employer’s contributions to the plan in addition to your own may be limited. For plan years starting after December 31, 1988, a hardship distribution is limited to your own contributions. Your employer’s contributions are usually subject to other rules for hardship withdrawals. Ask your company’s personnel, human resources or benefits office to find out what rules apply to your plan.

What taxes will I owe on a hardship withdrawal from my 401(k)?

If you qualify for a hardship withdrawal from your 401(k), you’ll owe ordinary income taxes on every nickel of the money you take out except for any money you might have contributed to the plan on an after-tax basis. On top of those taxes, you will also likely get slapped with a 10% early withdrawal penalty. Simply meeting the hardship requirements is not enough to avoid the 10% fine. To illustrate, say you are under age 59 1/2 and you withdraw $30,000 from your account for a qualifying hardship situation, such as buying a house or avoiding foreclosure. If your combined federal, state and local tax rate is 40%, then $12,000 of your withdrawal will be used to pay income taxes. Throw in a 10% early withdrawal penalty of $3,000, and the figure rises to 50%. In other words, you’ll get to keep only $15,000 of the $30,000 you pull out. In short, make an early withdrawal from your 401(k) only if you have nowhere else to get the money.

What is meant by a premature distribution from a retirement plan?

When you withdraw money from a retirement plan earlier than the age required by the Internal Revenue Service (59 1/2), the money you receive is known as a premature distribution and is subject to a 10% penalty unless you qualify for an exception to the penalty.

If I withdraw funds from my 401(k) early, will I have to pay a penalty tax?

As with most other types of retirement plans, the Internal Revenue Service levies a penalty on people who withdraw money from their 401(k) plan before they reach a certain age. As a general rule, you’ll be hit with a 10% penalty on any withdrawals you make from a 401(k) before you have reached age 59 1/2. You will also have to pay taxes on the money you take out, just as you would if you waited until after you turned 59 1/2. In rare cases, the IRS will waive the 10% penalty on early withdrawals. For example, you can avoid the penalty if you are disabled, or if you need money for medical expenses that are greater than 7.5% of your adjusted gross income. You can also avoid the penalty if you are at least 55 years old when you separate from service.

Why do I have to pay an early-withdrawal penalty for withdrawing my own 401(k) money?

Many people feel it’s unfair for the government to levy a 10% penalty when they make an early withdrawal for their 401(k) plan or Individual Retirement Account (IRA). After all, they point out, it’s their money -- not the government’s. Such feelings are understandable. But it’s important to remember that 401(k)s, IRAs and similar plans were created to reward you with certain tax breaks that would encourage you to save for retirement. The plans were never intended to be vehicles to save for pre-retirement expenses. By imposing a stiff penalty on early withdrawals, the government hopes to keep you from tapping the money early so you’ll have more left over for your golden years.

How is the 10% penalty on early withdrawals from a 401(k) calculated?

The 10% penalty on early withdrawals from a 401(k) plan applies to the entire taxable amount that’s distributed to you before you reach age 59 1/2 if you are still employed unless you meet one of the exceptions to the penalty.

How can I withdraw money from my 401(k) early without penalty?

By law, you may not withdraw funds attributable to elective salary reduction contributions until you reach age 59 1/2, are separated from service, become totally disabled or show financial hardship. Lump-sum withdrawals are also allowed if the plan terminates. If hardship withdrawals are allowed before age 59 1/2, you are generally subject to the 10% penalty for premature withdrawals. IRS regulations restrict hardship withdrawals. The IRS requires you to show an immediate and heavy financial need that cannot be met with other resources. Financial need includes the following expenses: purchase of a principal residence, tuition and related expenses, medical expenses, preventing your eviction or mortgage foreclosure and paying funeral expenses for a family member.

How does the "same desk" rule affect retirement plan distributions?

The "same desk" rule pertains to the situation where a company, a company division or other operation is sold to another company and the employees are transferred to the buyer company. The IRS has ruled that such a change in employers does not constitute a separation from service on the part of the employees, since they continue to work in the same "business" at the "same desk." Therefore there can be no distributions from the qualified retirement plan(s) of the seller. Note: The same desk rule is repealed effective January 1, 2002.

What happens to my 401(k) account when I retire?

If you have a 401(k) and retire, you will likely have four choices(assuming you are over 59 1/2). According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), those choices will be:
1. Taking the money in a lump sum. If you do, you’ll owe income taxes on all of it. The disadvantage is that after you’ve taken the lump-sum distribution, your money is no longer in a tax-deferred retirement account. That means that the only way to avoid tax on any future earnings is to invest it in tax-exempt instruments.
2. Rolling your entire balance into an IRA. Then you can take out money as you need it, paying income taxes only on the amount you withdraw. This gives you more flexibility than any other option. Most of your money will continue to be sheltered in a tax-deferred account. You’ll have a nearly unlimited choice of investments, too.
3. Taking a 401(k) payout as a lifetime annuity. Not all plans offer this. An annuity pays a monthly benefit for your lifetime alone or, if you choose a joint-and-survivor annuity, for your lifetime and your spouse’s. The advantage of an annuity is that it provides a guaranteed lifetime benefit. The disadvantage is that, because it’s a fixed amount, its purchasing power will be reduced every year by inflation.
4. Leaving some or all of the money in your 401(k). You must have at least $5,000 in your account to do this. This choice makes little sense, however, since, if you like the investments available in the plan, you can use those same investments in your own IRA and completely control you access to your money. If you leave it with the plan, you’ll need to comply with the plan administrator’s rules and proceedures for making withdrawals or changing investments.

How long after I retire will it take me to get my 401(k) money?

After you retire, there’s no legal requirement that says you must receive a check from your 401(k) plan by a specified date. The government merely requires that the plan pay you within 60 days after the end of the plan year during which you reach retirement age. This requirement gives 401(k) plan administrators lots of flexibility when deciding when to cut the checks for retirees. Any procedures your employer establishes within the guideline are OK, as long as they are uniform and treat all of the company’s workers equally.

What happens if I don’t start taking money out of my retirement account at age 70 1/2?

If you don’t start taking money out of your retirement account by the time you reach age 70 1/2, you’ll be hit with some extremely serious tax penalties. The Internal Revenue Service will slap you with a 50 percent excise tax on the difference between what you withdrew (if anything) from the account and what you should have withdrawn. On top of that, you’ll owe additional excise tax for each year you fail to make the required distribution. For example, if you should have taken $9,000 from the account but didn’t take out a cent, you would owe the IRS $4,500 for that year’s requirement. If you fail to make the required distribution for the following year,assume it’s $8,000, you will own another $4,000 for that year. And on top of all that, you’ll owe regular income taxes on each withdrawal as well!

How can ten-year forward averaging mitigate my tax liability on a lump-sum withdrawal from a retirement plan?

If you take a lump-sum withdrawal from a retirement plan and don’t roll it over into another qualified account, you will owe taxes on the entire lump sum. Fortunately, if you were born before 1936, you can reduce the tax bite by using an accounting method known as "ten-year forward averaging."
When you use ten-year forward averaging, you calculate the tax on one-tenth of the amount, using the 1986 tax table, and then multiply the tax by ten. For example, if the lump sum is $250,000, dividing by ten gives us $25,000. The 1986 tax table calculates the tax to be $5,077. Multiplying by ten we get $50,770 for the total tax on the distribution. When using this method, you can’t take any deductions or exemptions and you must pay taxes at the single taxpayer rate. Nonetheless, the tax you will owe by using forward averaging will likely be much less than without it.
You can use forward-averaging only once in your lifetime. To be eligible, you must have been in the plan for at least five years. In addition, you must stop working for the employer who pays the lump sum and take all the retirment plan account balances in lump sum. Lump-sum pension payments involve some extremely important tax issues, and forward averaging is only one of them. Anytime you are considering taking a lump-sum payment, talk to a tax and financial planning specialist first.

When did five-year forward averaging cease to be available?

Five-year forward averaging was not available after December 31, 1999.

Can I take a lump-sum distribution from my 401(k) plan and use five-year averaging, even though I am only 57?

Five-year averaging has been repealed and can no longer be used.

I am retired and when I got my 401(k) money, the amount was based on the value of my account as of two months earlier. Why didn’t I receive any interest for those last two months?

When you retire and get the proceeds from a 401(k), the size of the check will be based on the most recent valuation of your account. If the most recent valuation was made two months ago, you’ll get the amount that your account was worth two months ago. Don’t worry. You’re not being cheated. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Theoretically, your withdrawal and the valuation date match perfectly. But in real life, there’s an information lag. If your withdrawal is on December 31, for example, the plan’s recordkeeper may not know the exact value of your account on December 31 until several weeks later. The more frequently a 401(k) plan values accounts, the shorter the time lag. Theoretically, there is no time lag in a plan that is valued daily. In reality, participants don’t always receive a distribution check that includes interest up to the date the check was cut. So what happens to the lost interest? It’s credited back to the plan and shared by all the participants. In other words, you have benefited from this time lag in the past when other people left the plan. If you’ve been in the plan for a long time and many other people have left, you may even be ahead of the game."

Can I take my money out of my 401(k) plan if I stop contributing to it?

According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "The fact that you’re no longer contributing to the plan doesn’t mean you can start taking withdrawals. There are only three ways to take money out of your 401(k) account: distributions, early withdrawals and loans. You can take distributions after age 59 1/2 when you leave your job; you can take early withdrawals only for reasons specifically approved by the Internal Revenue Service and the plan. Whether or not you can take a an early distribution or a plan loan depends on your plan’s rules."

Can I empty my 401(k) account without my spouse knowing about it?

If you’re married, your spouse can’t empty your 401(k) plan without you knowing about it. However, you can’t necessarily empty the account and keep it a secret from your spouse, either. For example, if your 401(k) follows conventional joint-and-survivor rules, your spouse is legally entitled to a share of your retirement payout in the form of lifetime annuity payments. As a result, your plan could require that your spouse approve any loans or hardship withdrawals that you try to take from the account.

Can my spouse empty my 401(k) account without my knowledge?

Your spouse can’t touch your 401(k) unless you die or get divorced. However, your spouse is legally entitled to be the designated beneficiary of your account, which means he or she can claim all the money when you die. In fact, the Internal Revenue Code says that your spouse must be named the beneficiary of any qualified retirement plan in which you are involved -- including 401(k)s and IRAs -- unless he or she signs a consent waiver that surrenders that right.

Must my spouse agree to a loan from my 401(k) plan?

If you are married and hope to borrow from your 401(k) plan, your spouse’s approval may be required. Your spouse’s approval will certainly be required if your 401(k) plan follows standard joint-and-survivor rules, which means that you and your spouse have the option of receiving your retirement payout in the form of lifetime annuity payments. Your company’s human resources, personnel or benefits department can give you the details.

If I get divorced, is my spouse entitled to a share of my 401(k) account?

Financial concerns alone are not enough for you to stay married if your spouse is making life miserable. But if you have a 401(k) and get divorced, your husband or wife will probably be entitled to a share of the money in your retirement account. The money that accumulates in a retirement account during marriage is considered a marital asset, and marital assets are divided between divorcing spouses. The formula for dividing those assets depends partly on your specific circumstances and partly on the laws of the state in which you live. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "In community property states, marital assets in general are split 50/50. This doesn’t mean each specific asset is cut in half, but rather that the entire marital estate is divided. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. "In equitable distribution states, marital assets are divided equitably -- i.e., fairly, which doesn’t necessarily mean a 50/50 split. The ultimate decision of what’s fair is made by the court. In general, the court determines how much of your pension plan is a marital asset by dividing the number of years you’ve been married by the number of years you’ve been a plan participant. For example, if you’ve been married for two years and a plan participant for three years, two-thirds of your pension would be considered a marital asset. All other things being equal, your spouse would get half of that two-thirds." A distribution from a qualified plan remains qualified and can be rolled over by the spouse receiving such distribution or rolled to his or her qualified plan at work provided the distribution is done through a Qualified Domestic Relations Order (QDRO) approved by the plan administrator and adjudicated by the court. Divorce can create lots of complex legal, investment and taxation issues. It’s imperative that both parties get the advice of qualified experts to address such matters.

What is a Qualified Domestic Relations Order (QDRO)?

A QDRO is a court-ordered disposition of marital property specifically addressing the assets in a qualified retirement plan, such as a pension account or 401(k). The QDRO creates an alternate payee and assigns the alternate payee the right to receive plan benefits payable to the plan participant. The participant’s spouse, former spouse, or dependent may be designated as the alternate payee. IRAs, on the other hand, are adjudicated by divorce decree and subject to state law. Qualified plan assets are protected under ERISA (Federal law) and must be distributed according to the QDRO.

How can I transfer part of my retirement plan assets to my former spouse without paying taxes on the withdrawal?

A court ordered disposition of qualified plan assets under a QDRO will not result in a taxable transaction. A QDRO is a court-ordered disposition of marital property specifically addressing the assets in a qualified retirement plan, such as a pension plan or 401(k). The QDRO creates an alternate payee and assigns the alternate payee the right to receive plan benefits payable to the plan participant. The participant’s spouse, former spouse, or dependent may be designated as the alternate payee. The QDRO allows the plan administrator to make the distribution. If the retirement plan assets are in an IRA, the division and distribution must be adjucated by the court and a distribution order made. Otherwise the distribution may be deemed a withdrawal subject to penalty and taxes.

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