What’s the difference between withdrawing from a 401k and taking out a 401k loan?

When life happens and there’s a big bill attached, we often scramble to figure out how to pay it. Ideally, an unexpected expense should be covered by your emergency savings account. If you don’t have enough savings, consider asking for a payment plan or delaying the bill until you get a tax return or bonus.

If those options don’t work, as a last resort, you may be able to use your 401k plan. It’s considered a last resort because the purpose of a 401k is to save money you may need when you’re older and possibly unable to work. There are two options to taking money out of a 401k while you are working: a hardship withdrawal or a 401k plan loan.

401k Hardship Withdrawals

You take money out of your 401k plan for a specific IRS-approved hardship (prevention of eviction, education expenses, etc.) and you’re not returning the funds. Here are a few details you should be aware of:

• With few exceptions, the amount you withdraw is taxed.
• You may also owe a 10% penalty if you remove the money before you are 59 ½ years of age.
• The amount withdrawn is restricted to what you need to cover the hardship. You will need documentation to prove your hardship and hardship amount.
• Many employers will not allow you to contribute to a 401k plan for about six months after your withdrawal.
• If you choose a 401k hardship withdrawal, you can have additional taxes taken out of the amount received. However, many find they still owe taxes or get a much smaller (or no) refund. Talk to a tax professional to make sure you withhold the correct amount of taxes. If you take out a 401k plan loan, your take-home pay will be less because the loan payments come directly out of your paycheck. Adjust your spending to account for the lower paycheck.

401k Loans

You borrow against your 401k plan and paying an interest rate given to you by your employer. The payments typically last 1-5 years. If you are using the money to buy a home, you may be able to take longer to pay. You pay yourself back through monthly payroll deductions.

• Because it’s a loan, you typically do not owe taxes, as long as you are making the payments.
• Some companies may restrict how much you can take out and how often you can request a 401k loan. Contact your 401k plan for more information.
• If you leave your job, your company may require you to pay the remaining loan balance back in full within a specific time frame. If you do not pay the money back or roll it over within a particular time frame, the remaining loan amount is typically taxable. You may also have to pay a 10% penalty on the remaining balance if you are under 59 ½.

To avoid having to use your 401k plan for emergencies, open a savings account and start with an amount you can easily save (ideally through payroll deductions). If you get a 401k plan loan, once the loan payments end, consider having the former loan amount automatically deducted from your payroll into a savings account. These steps will go a long way into turning an unexpected expense from a crisis to a minor inconvenience.