Should You Borrow or Take a Distribution from Your 401(k)?
Written by Merrill a Bank of America Company
Before borrowing from your 401k, you might want to consider alternatives first. In this article, Bank of America explains why and how.
When there’s a sudden need for a substantial amount of cash, many people think about taking money out of their 401(k)s. “It is understandable that people may want to consider doing so in extraordinary circumstances such as the coronavirus pandemic,” says Sylvie Feist, director, Retirement & Personal Wealth Solutions at Bank of America. What’s more, provisions of the Coronavirus Aid, Relief, and Economic Security (CARES) Act have eliminated potential additional penalties when taking an early distribution, and increased the portion of the vested assets that can be taken in a loan from a 401(k) plan account.
“In some circumstances, your 401(k) may be your only choice. But as a general rule, dipping into your retirement funds to cover a short-term need could cost you more in the long run.,” Feist says.
A lost opportunity to grow your savings
Before deciding, consider that when borrowing from your retirement funds, “you’re interrupting the potential for the funds in your 401(k) plan account to grow through tax-deferred compounding, making it more difficult for you to reach your retirement goals,” says Feist. Taking funds out might also mean missing out on potential future earnings.
What happens if you leave your job before the loan is paid off?
Depending on the plan, you may be required to pay the amount back immediately or else have it deemed a distribution from the plan. “This is called a loan offset,” explains Feist. “You may be subject to federal and state income taxes, as well as an additional 10% federal income tax if you are under age 59½, unless an exception applies,” she adds. Under the Tax Cuts and Jobs Act of 2017, you must repay the amount to an IRA by the federal income tax filing deadline for the year in which the offset occurred.
How the CARES Act changes things
If you are eligible and your employer’s 401(k) plan permits, you may take a coronavirus-related distribution, or CRD, up until Dec. 31, 2020.1 It gives you access to as much as $100,000 of all your eligible employer-sponsored retirement plan or IRA assets.
CRDs are not subject to the additional 10% federal income tax that applies to individuals under age 59½, or the mandatory 20% federal income tax withholding when taken from an eligible employer-sponsored plan account. Also, federal income taxes on CRDs may be paid evenly over a three-year period, beginning with the year that the distribution was made.
In general, CRDs may also be repaid to an eligible employee-sponsored retirement plan within three years from the date of the CRD. The repayment will be treated as a rollover and will not be counted towards your annual contribution limits.
Though the CARES Act makes it easier to use a 401(k) plan account for financial assistance, Feist suggests that potential borrowers think about their long-term financial security. “Before you consider making a withdrawal from your future self, make sure you have explored other options.”
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
1To be eligible for a CRD, you must be an individual who is diagnosed with the virus SARS-CoV-2 or with coronavirus disease 2019 (COVID-19) by a test approved by the Centers for Disease Control and Prevention, or whose spouse or dependent (as defined in the Internal Revenue Code) is diagnosed with such virus or disease by such a test, or who experiences adverse financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to such virus or disease, being unable to work due to lack of child care due to such virus or disease, closing or reducing hours of a business owned or operated by the individual due to such virus or disease, or other factors as determined by the Secretary of the Treasury.
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