What’s the difference between a 401k loan and withdrawal?

When you contribute part of your paycheck for retirement, you expect to use these savings in retirement. However, there are situations when you may need quick cash and you have no other options apart from your 401(k) savings. In this case, you could consider making a 401(k) withdrawal or taking a 401(k) loan to meet your financial needs. Before deciding how to take money out of your 401(k), you should consider the financial implications of each option.

A 401(k) loan lets you borrow against your retirement savings, and you must pay back this money over a five-year period. In contrast, a 401(k) withdrawal permanently removes money from your 401(k), and you won’t be required to pay back the money. However, a 401(k) withdrawal is subject to income taxes, and a potential penalty if you are below 59 ½. A 401(k) loan is not subject to income taxes or early distribution penalties unless you default on the loan.  

401(k) Withdrawal

If you have an immediate financial need and require cash urgently, you may decide to take a 401(k) withdrawal. Usually, if you are below age 59 ½, you may be allowed to take a hardship withdrawal, but it can only be used to pay for qualified expenses such as unreimbursed medical expenses, college expenses, and to prevent a foreclosure.

You must also be facing an immediate financial need to qualify for a hardship withdrawal. If you qualify, you may not withdraw more money than you need to cover the hardship situation.

Unlike a 401(k) loan, you will not be required to pay back the money taken out of your 401(k). However, the hardship withdrawal is considered a premature distribution, and you will pay income taxes, in addition to an early withdrawal penalty if the expense does not qualify for a hardship withdrawal.

Pros of Hardship Withdrawal

You get cash quickly

If your 401(k) plan allows hardship withdrawals, you will get a disbursement check in a few days after you make a request.

No repayment needed

Once you take a withdrawal, you will keep the money for yourself, and you won’t be required to pay back the money.

Cons of Hardship Withdrawal

You will owe taxes

You will pay ordinary taxes on the amount you withdraw from your 401(k) at your tax bracket.

If you are below 59 ½, you will pay a 10% penalty for early distributions. However, if the expense qualifies for a hardship distribution, you will be exempted from paying the 10% penalty.  

Reduced contributions

When you take a 401(k) withdrawal, your 401(k) balance drops, and you will have less money available for retirement. Depending on how much you take out of your 401(k), it will be difficult to replenish your account, and you may be forced to work several more years to attain your retirement goals.

401(k) Loan

If your plan allows 401(k) loans, you can opt to take a 401(k) loan instead of a 401(k) withdrawal. A 401(k) loan lets you borrow against your retirement savings, and you can borrow up to 50% of your vested balance, or a maximum of $50,000.

Once you are approved for a 401(k) loan, you must pay back the loan in substantially equal payments over a five-year period. The repayment period for 401(k) loans can be higher if you are using the loan proceeds to buy your primary residence. You will pay interest on the 401(k) loan, and the loan payments will be made to your 401(k) account. Some plans may require spousal consent to approve a 401(k) loan.

Unlike hardship withdrawals, there is no limit on how you can use the 401(k) loan. You can use the funds for any purpose you want such as paying for a vacation, college fees, medical expenses, down payment for a home, etc.

Most employers only allow one loan at a time, and you must pay off the current loan before being approved for a second loan. However, some plans may allow multiple loans at a time, but the maximum loan limit rules still apply.

Pros of 401(k) loan

Borrow from your old 401(k)

Beagle unlocks your old 401(k)s, and lets you borrow against your old 401(k)’s savings at 0% net interest.

Quick approval

As long as you have a sufficient balance in your 401(k), you will be approved for a loan. Also, there are no credit checks involved, and this shortens the loan processing period.

Loan Interest paid back to your account

Loan interest is paid back to your 401(k) to help replenish your balance and the lost savings. Hence, no money is lost to an external lender.

Cons of 401(k) loan

Risk of default

If you default on the loan, the outstanding loan balance may be considered a distribution that is subject to taxes. If you are below 59 ½, you will owe a 10% penalty for early distributions. 

Opportunity cost

When you take a 401(k) loan, you will have a reduced balance in your 401(k). Hence, there will be less money earning interest and growing through compound interest