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Is It Better to Borrow from 401k Loan vs Personal Loan?
What are the advantages and disadvantages of 401k loan vs personal loan? No longer in awe.
We’ll lead you through each one. Therefore, your bank account is on life support and you’re considering taking out a personal loan or borrowing against your 401(k) plan.
Personal Loan vs 401(k) Loan
When you require more than what a credit card can supply (at a reasonable fee) and home equity financing is not an option, personal loans and 401(k) loans may be ideal.
Both are simple to apply for and both provide immediate access to funds.
The primary distinction between these two types of loans is that personal loans are unsecured.
This means that if you default on the loan, there is no collateral to secure it.
There is nothing for a lender to seize. While a 401(k) is guaranteed by the amount of money in your retirement account.
In the case of the 401(k) account, the lender is you. You are taking a loan from yourself.
Personal Loan Pros and Cons
Pros:
➣ Personal loans are unsecured loans that do not require collateral. If you default on a loan, the lender cannot seize your home, car, or retirement account amount.
➣ Interest rates are set in stone. Interest rates on personal loans are virtually always fixed. This simplifies budgeting.
➣ Installment loans have a set duration. Personal loans have a predetermined expiry date due to the fact that they are installment loans. Your debt will not last indefinitely.
➣ You can borrow between $1,000 and $100,000. Setup fees are minimal and are often based on the loan amount. As a result, a smaller loan typically has lower interest rates.
Cons:
➣ A lender may say “no.” Lenders of personal loans are in business to make money.
If your obligations are too large or your FICO score is too low, you may be unable to obtain or afford a personal loan.
➣ Payments may be substantial. Due to the fixed terms of personal loans, your payment will almost certainly be more than the minimum on a credit card and probably higher than a five-year 401(k) loan.
This is beneficial for debt repayment but may be detrimental to your cash flow.
401(k) Loan Pros and Cons
Pros:
➣ Likely approval – As long as your employer’s plan permits borrowing and your balance is healthy, obtaining approval should be quick.
➣ The interest accrues for you – While you are required to pay interest on a 401(k) loan (sorry), the interest accrues to you. On the plus side, you’re paying yourself interest.
➣ Late payments are not subject to penalty. Payments that are late or missed are not recorded to credit bureaus.
Cons:
➣ You may wish to postpone your retirement plan – You cannot contribute to your plan while you are in arrears on it.
This means that your tax bill will almost certainly be greater. Additionally, you return the loan with after-tax funds, reducing the amount of money available for retirement savings.
➣ Fees may make it unprofitable – 401(k) plans frequently charge fees for loan administration.
If you take out a little loan, the charge you pay may offset some of the loan’s value.
Furthermore, if the loan is tiny but comes with a high cost, you may be better off borrowing money in another manner.
➣ Possibility of incurring a tax penalty – If you leave your work or are laid off, you must repay the 401(k) loan by the end of the tax year. What if you do not?
According to IRS regulations, your loan may convert to an unqualified distribution from the plan, in which case you will owe regular income taxes on the remaining balance – plus a 10% penalty.
➣ Maximum loan amounts – You may be unable to borrow as much as you anticipated.
Generally, you cannot borrow more than half of the loan’s total up to $50,000.
Having said that, if your plan balance is less than $20,000, you may borrow up to $10,000 or the balance’s total amount (whatever is less).
Additionally, depending on the plan, you may have additional limitations prohibiting you from borrowing a set amount.
Which Is Better for You: A Personal Loan or a 401(k) Loan?
Should you take out a personal loan or contribute to your 401(k)? Regrettably, there is no general response. It truly depends on your circumstances.
If you qualify for the lowest interest rates and can afford the monthly payment, the case for a personal loan is compelling.
You’d also choose a personal loan if your working status is tenuous, if you’re looking for work elsewhere or your position is precarious for whatever reason, a personal loan is significantly less hazardous than a 401(k) loan.
It’s pointless to save 15% on interest if you’re charged with a 40% penalty for leaving your company.
A personal loan is also a viable option if your borrowing needs are limited to a few thousand dollars.
This is because the setup and administration costs of a 401(k) loan can be disproportionately expensive when the loan amount is small.
On the other hand, you have a compelling case for taking out a 401(k) loan if you are really secure in your position.
That is especially true if your credit score is insufficient to qualify for an affordable personal loan interest rate.
Most 401(k) plans do not charge you additional interest if your credit is poor, and in any case, you repay the interest.
Another advantage of 401(k) loans is that missed payments can be made without incurring penalties or affecting your credit.
If you accept a 401(k) loan and subsequently want or need to leave your employment, you may be able to avoid some or all of the tax penalties by repaying the 401(k) loan with a personal loan.
Leaving Your Job With a 401(k) Loan? With a Personal Loan, You Can Avoid Penalties
The Employee Benefits Research Institute estimates that around one-fifth of eligible employees with 401(k) plans borrow against them.
Having said that, it can be a hazardous maneuver. You may wind up owing taxes and penalties equal to up to 50% of the loan amount.
This could occur in one of three ways:
➣ You resign and seek employment with a different employer.
➣ The company for which you work closes its doors.
➣ You’ve been laid off or terminated.
If there is a significant chance that you may lose your work before repaying the 401(k) debt, consider repaying it with a personal loan.
If you’re worried about your job stability, apply for a personal loan now before you lose your work.
Period for Repayment of 401(k) Loans
If you do decide to leave your employment, you can avoid the penalty on your 401(k) loan by repaying it before to the deadline for filing your next year’s tax returns.
You can even obtain an extension if necessary. Therefore, if you left your work in January 2019, you should have until October 15, 2021, to repay your 401(k) loan, plus an extension.
Penalties for Not Repaying Your 401(k)
If you miss the deadline for reimbursement, your employer will file a Form 1099-R with the Internal Revenue Service.
If this occurs, the outstanding loan balance is treated as income and is taxed at your regular income tax rate.
Additionally, you’ll pay a 10% penalty on the amount if you’re under the age of 55 and retired (in some situations, under the age of 50 for police, firefighters, and EMTs) or under the age of 59 1/2 and still working.
The mathematics can be quite unpleasant. Assume you owe $10,000 on your 401(k) when you quit your employment and your federal tax bracket is 32%.
Your state’s rate is 5%. You are still young, employed, and owing a 10% penalty.
That’s a total of 47%. Instead of repaying the $10,000 loan, you must repay $14,700!
The mathematics becomes even more heinous. The IRS assesses an underpayment penalty and interest on that $14,700 balance until the debt is satisfied.
As of this writing, that equates to 0.5 percent each month + 5.72 percent interest.
Therefore, if it takes five years to pay off your IRS obligation, your monthly payment would be approximately $325.
When the smoke clears, you will have paid $9,495 for a $10,000 loan.
Pay Your 401(k) Loan with a Personal Loan to Avoid Penalties
If you have difficulty repaying the 401(k) loan, you may wish to consider repaying it with another 401(k) loan.
To begin, your loan will not be considered income by the IRS, allowing you to avoid income tax and the penalty.
These figures are subject to change, but the average personal loan now has an interest rate of somewhat less than 11%.
If you owe $10,000 on a 401(k) loan and wish to avoid the IRS, your payments at 11% over five years would be $217 and borrowing $10,000 would cost $3,045.
Summarizing 401k Loan vs Personal Loan
➣ The 401(k) loan is less expensive as long as you repay it on time, do not leave your job, refund the loan as quickly as feasible, and raise contributions to boost retirement savings after you are debt-free in your 401(k).
➣ A personal loan may be less expensive if you have excellent credit and do not require a large sum of money.
➣ A 401(k) loan provides a more affordable option for persons with poor credit, as long as they repay the loan without incurring penalties.
➣ You may be able to avoid IRS penalties by repaying your 401(k) loan with a personal loan.
However, you are unlikely to qualify if you leave your work. Arrange for a personal loan prior to terminating your employment.
To make an informed selection, obtain personal loan quotations and determine whether you can afford the installments.
Inquire about your company’s 401(k) plan and verify its rules. By and large, 401(k) loans are less expensive but riskier. Personal loans are more expensive but safer.
401k Loan vs Personal Loan Frequently Asked Questions
Myth: You’ll pay taxes twice. However, that statement greatly exaggerates the tax costs of taking a 401(k) loan; the only money “taxed twice” in the transaction is the interest paid. Meanwhile, the 401(k) borrower is able to take the loan, consisting of money that has never been taxed, without tax consequences.
It doesn’t matter if you leave voluntarily, or you are terminated. You have to pay back the 401(k) loan in full. Under the Tax Cuts and Jobs Act (TCJA) passed in 2017, 401(k) loan borrowers have until the due date of your tax return to pay it back. Prior to this, loan borrowers had 60 days to pay it back.
Usually, a 401(k) loan has more favorable terms than a regular bank loan, and it is a good alternative if you do not want to withdraw your retirement money. If you are currently paying off a 401(k) loan, you can choose to pay off the outstanding loan balance earlier than the allowed loan term.
Fortunately, when you repay your 401(k) loan, the interest goes back into your 401(k) account. Rather than being lost to a bank, you keep the interest you pay on your 401(k) loan to build until you retire.
401(k) and IRA Withdrawals for COVID Reasons Section 2022 of the CARES Act allows people to take up to $100,000 out of a retirement plan without incurring the 10% penalty. This includes both workplace plans, like a 401(k) or 403(b), and individual plans, like an IRA.
A 401(k) loan can’t be forgiven. If you default on a 401(k) loan, you won’t have to repay the outstanding balance, but the IRS will consider the 401(k) loan as an early retirement withdrawal. Subsequently, you’ll be hit with a 10% penalty tax on top of income tax.
If you recently became unemployed, your former employer may not allow you to take a 401(k) loan. Once you leave your job, you will no longer receive paychecks that the employer can deduct to pay the loan. Instead, you will be solely responsible for making loan payments.
The IRS will penalize you. If you withdraw money from your 401(k) before you are 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government $1,000 or 10% of that $10,000 withdrawal in addition to paying ordinary income tax on that money.
When you take 401(k) distributions and have the money sent directly to you, the service provider is required to withhold 20% for federal income tax. If this is too much, if you effectively only owe, say, 15% at tax time, this means you’ll have to wait until you file your taxes to get that 5% back.
A hardship distribution is a withdrawal from a participant’s elective deferral account made because of an immediate and heavy financial need and limited to the amount necessary to satisfy that financial need. The money is taxed to the participant and is not paid back to the borrower’s account.
Once you have attained 59 ½, you can transfer funds from a 401(k) to your bank account without paying the 10% penalty. However, you must still pay income on the withdrawn amount. If you have already retired, you can elect to receive monthly or periodic transfers to your bank account to help pay your living costs.
You do not have to prove hardship to take a withdrawal from your 401(k). That is, you are not required to provide your employer with documentation attesting to your hardship. You will want to keep documentation or bills proving the hardship, however.
The safest place to put your retirement funds is in low-risk investments and savings options with guaranteed growth. Low-risk investments and savings options include fixed annuities, savings accounts, CDs, treasury securities, and money market accounts. Of these, fixed annuities usually provide the best interest rates.