The coronavirus pandemic raging in 2020 has forced many Americans to do something they probably never thought they had to do – take out a loan as part of their 401 (k) plan. In fact, recognizing the economic devastation brought on by the pandemic, the IRS has actually expanded the use of 401 (k) loans. While traditionally you can only borrow the lesser of $ 50,000 or 50% of your vested 401 (k) balance, for part of 2020 these limits have been raised to $ 100,000 and 100%, respectively.
If you are one of the Americans who has taken out a 401 (k) loan, you might be wondering what the next steps are. Here’s a quick rundown of the things you need to know about your loan, along with some tips on what to avoid.
Last updated: July 21, 2021
Understand your repayment terms
When you take out a 401 (k) loan, you might feel like you’re just withdrawing money from your account or borrowing yourself. But a 401 (k) loan is an actual loan, which means that you will have a monthly repayment schedule, a stated interest rate, and a loan due date.
Luckily, most 401 (k) administrators make the process pretty straightforward and straightforward, meaning you’ll be notified of all of your loan terms, with automatic payments set up. However, you need to know the due date of your loan, the amount of your monthly payment, the amount of interest you are paying, and the penalties incurred if you fail to meet your obligations.
While you may feel like you are just withdrawing money from your own emergency fund or bank account, there are actually many rules associated with your 401 (k) loan, and you must all of them. learn and understand them.
Hold on to your work
Obviously, everyone wants to keep their job, especially in times of high unemployment. But if you’ve taken out a 401 (k) loan, it’s absolutely essential that you don’t lose your job if you want to avoid big financial hassles. While most 401 (k) plan loans can have maturities of up to five years, if you quit your job for any reason, you may need to pay off your loan quickly.
IRS regulations require the repayment of 401 (k) loan balances on the day of the tax return the year after you leave your job. So, if you are made redundant in October 2020, for example, you will have to repay your loan by April 15, 2021. If you do not repay your loan, it will be treated as a distribution. This means that you will owe income tax on your entire outstanding loan balance, in addition to a potential 10% early withdrawal penalty if you are under 55.
Make additional payments
Just because your 401 (k) loan has a five-year term with modest monthly payments, doesn’t mean you can’t pay off your loan faster. In fact, it could be a prudent financial decision. As with any standard loan, the faster you pay off your 401 (k) loan, the less interest you will pay. Plus, making extra payments on a 401 (k) loan offers a huge added benefit: the sooner you can pay off your loan, the faster those payments can be used to build up your retirement account instead.
Understanding how interest charges work
One of the main distinctions between a 401 (k) loan and other types of loans is that you pay the interest on your own account, rather than on a bank or other financial institution. In that sense, taking out a 401 (k) loan might not seem so bad, since you are essentially keeping that interest rather than paying it to someone else. However, there is a huge catch. The interest you pay back on your account is in after-tax dollars. When you take it out of your 401 (k) at retirement, you’ll pay tax on your entire distribution, including any interest you paid back on your own account. So you will end up being taxed twice on those same dollars. This makes a 401 (k) loan an inefficient use of your money.
Maintain your investment plan
An important thing to remember if you take out a 401 (k) loan is that your long-term retirement goals haven’t changed. Just because you take out a loan doesn’t mean you need to reduce the risk in your investment portfolio. Instead, you should keep your original asset allocation in your 401 (k). Since it might take you five years to pay off your 401 (k) loan, transferring your assets to cash would mean you essentially skip five years of investment gains. That’s an eternity in terms of compound earnings, and may be enough to keep you from reaching your long-term retirement goals. Avoid this temptation and keep investing like you don’t have any loans.
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This article originally appeared on GOBankingRates.com: What to do if you borrowed money on your 401 (k) in 2020