Why borrowing from your 401(k) is better than cashing out your IRA
In our perfect world, you’d never need to borrow from your 401(k) OR cash out your IRA. We don’t intend to recommend either of these strategies by writing about them, however, sometimes people run into a cash crunch and after exhausting other options turn to their retirement savings for help.
Let’s look at a hypothetical example of a couple who needs $50,000:
A couple with income of $250,000 choosing to take $50,000 out of their IRAs would have that withdrawal taxed at the 33% Federal Income Tax level. That’s $16,500 in taxes, and can start a cycle of needing to make more withdrawals. If the couple has to make another IRA withdrawal to pay the 16,500 tax, they’ll need to take out another $5500, creating another taxable event and depleting the IRA further.
If the couple has not reached the age of 59.5 yet, and doesn’t have a qualifying expense*, the withdrawal will also be assessed a 10% penalty. The IRA distribution itself is not assessed the Medicare surtax but it could trigger the surtax threshold, making other investment income subject to an additional 3.8% tax.
Instead, if the couple borrowed the same $50,000 from their 401(k) it is not a taxable event, the interest on the loan will be relatively low, and the interest is paid back into their own 401(k) as they make payments. 401(k) loans are usually 5 year loans, but can be extended to 10 years when using the money to purchase a primary residence.
401(k) plans have loan limits and repayment rules, and regulations are set up to keep people from using a 401(k) like a line of credit, but in an emergency your 401(k) may be a welcome source of liquidity.
If Mission Financial Planning was working with this couple, we would look at the bigger picture for other sources of liquidity, the availability and tax implications of other types of borrowing, and of course we’d diagnose what created the financial emergency in the first place. Our mission is to get clients to a place of financial strength, prepared in advance for the financial events that might come their way.
*IRA distributions made before age 59.5 may avoid the 10% penalty in a handful of circumstances including when used for college expenses, up to $10,000 is withdrawn for a home purchase, upon disability and to provide an income stream based on life expectancy. Withdrawals can also be penalty free for medical expenses and health insurance, but even more restrictions apply.