Can I use my 401k as collateral for a loan?
If you are considering using a 401(k) as collateral for a loan, find out what IRS rules say, and the risks of using 401(k) as collateral.
When you need immediate financing, you may consider using a 401(k) as collateral. Usually, lenders require borrowers to provide security for a loan, which protects the lender from loss in the event of default. Using a 401(k) as collateral for a loan presents a plethora of negative consequences that put your retirement money at risk.
The Internal Revenue Service (IRS) does not allow 401(k) participants to use their retirement accounts as collateral for a loan. If you pledge your 401(k) as collateral, the IRS considers this as a full disbursement of your account, and you will be required to pay taxes in the year when the assumed disbursement occurs, and a 10% penalty tax if you are below 59 ½. Also, since the 401(k) is protected from creditors by the ERISA Act, the lender cannot access the 401(k) money to pay off a defaulted loan.
Why 401(k) Cannot Be Used as Collateral for Loan
Some of the factors that make it impossible to use 401(k) as collateral for a loan include:
401(k) account is managed directly by the employer
A 401(k) is held in the name of the employer on the employee’s behalf, and the 401(k) plan determines when and how a participant can withdraw money from their 401(k). This is different from an IRA that is held in the account holder’s name, and the owner is fully responsible for the account.
The 401(k) plan managed by the employer determines when an employee can withdraw money from the account. Usually, some employers may allow early withdrawals or 401(k) loans when a participant is facing financial hardship. Since a 401(k) does not give the participant full control of the retirement money, a participant can't use the account as collateral for a loan.
The Employee Retirement Income Security Act (ERISA) protects 401(k) and other retirement accounts from creditors. If you owe money to a creditor or you filed for bankruptcy, the creditors cannot seize your retirement money to settle a debt. Therefore, the creditor will have to access other assets owned by the borrower such as motor vehicles, real estate property, and savings accounts to collect the debts owed.
Risks of Using 401(k) as Collateral
The IRS prohibits 401(k) participants from using 401(k) accounts as collateral for a loan. Here are the risks involved if you use your 401(k) as security for a loan:
You will owe taxes on your entire account balance
When you use your retirement account as collateral, the IRS considers the entire account balance of your account as a distribution. This means that the account balance is considered an income in the year when the 401(k) was used as collateral, and the money will be taxed at your tax bracket rate. If you are below 59 ½, you will also be required to pay a 10% penalty tax. For example, if your 401(k) balance is $300,000, you may be required to pay up to 40% in taxes i.e. $120,000.
You will forego tax benefits of a 401(k)
If the IRS discovers that you used your retirement account as collateral for a loan, you could lose the tax benefits of your 401(k) account. Your retirement money will no longer grow tax-deferred, and you won’t be able to make further contributions to the account. Also, you will lose creditor protection, and creditors can seize the funds to enforce a court order.
Alternatives to Using 401(k) as Collateral
Instead of using a 401(k) as collateral, a participant can access the retirement money in the following ways:
Borrowing against 401(k)
If your 401(k) plan allows participants to take a 401(k) loan, you can request to borrow a loan against your retirement savings up to your available limit. Depending on the terms provided in the 401(k) plan documents, you may be able to borrow up to half of your vested balance, up to a maximum of $50,000. Once you determine the amount of loan you want to borrow, you should make a request to the plan sponsor.
One of the benefits of borrowing from a 401(k) is that it does not require a detailed loan application or credit check. Once approved, you should expect to receive funds within a few days. Also, the interest paid on the loan goes back to your 401(k) account, and it helps grow your retirement money further. On the downside, taking money out of a 401(k) account denies your retirement money tax-deferred growth, and you may never make up for the loss of appreciation opportunities.
Withdrawing from 401(k)
A 401(k) plan may also allow participants to take a distribution from their retirement account even if they are below the required retirement age. A participant may take a hardship withdrawal, provided the withdrawal meets the criteria regarding the need to be satisfied and the amount. A hardship distribution can be used to pay college fees, medical expenses, funeral expenses, etc. You may be required to provide evidence of financial need when requesting a hardship withdrawal.
When you withdraw money from a 401(k), you will owe income taxes on the distribution amount. If you have a financial hardship and below 59 ½, the IRS may waive the 10% penalty tax on early withdrawals. The IRS may also waive the 10% penalty for other reasons such as physical disability and mental illness.