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401(k) Loan vs. Taxable Distribution

401(k) Loan vs. Taxable Distribution
5 Minute Read

Many people consider tapping into their retirement accounts to pay for emergencies, address financial hardship, or invest in themselves. However, people frequently ask, what is better, a 401(k) loan or a taxable distribution? In this article, we will discuss options that will allow you to access your 401(k) funds.

Key Points
  • If your plan allows for it, the 401(k) loan is the superior option to a distribution
  • There are no taxes or penalties owed, and you pay the plan back
  • If you are self-employed, you can open a Solo 401(k) plan that has a loan feature

401(k) Loan

Some 401(k) plans have a loan feature. If you are eligible, and work in a business that offers a 401(k) plan, ask if they have a loan feature. If your plan allows for one, you can borrow up to $50,000 or 50% of your account value, whichever is less. For example, if you have $100,000 in your 401(k), you can borrow $50,000. If you pursue a 401(k) loan, you will have five years to pay back the loan. Payments must be made at least quarterly. However, you do have the option to pay it back weekly, biweekly, or monthly. It is important to mention that 401(k) loans do carry an interest rate. As of June 2022, interest rates are going up.

Benefits of a 401(k) Loan

If your 401(k) plan allows for a loan, the funds can be used for any purpose. For example, individuals can use a 401(k) loan to pay rent, housing expenses, medical bills, or even to go on vacation. You can also use a 401(k) loan to start your own business. In general, there are no restrictions on what you can use a 401(k) loan to fund. The only restriction is to ensure that your loan is paid back on time. If you miss a payment, you do have the ability to rectify the situation, but only if you make up the missed payment in the same taxable year.

Another benefit of a 401(k) loan is the ability to avoid credit card debt. As rates continue to rise, individuals carrying high credit card balances will experience higher monthly payments. Therefore, a 401(k) loan may be a practical option for some individuals.

What if my 401(k) Plan Does Not Have a Loan Feature?

This is a common question IRA Financial Group receives almost daily. Good news if you are self-employed. You have the option to take out a Solo 401(k) loan. Or if you recently lost your job and decide to become self-employed, you also have the option to rollover your 401(k) into a new Solo 401(k) plan and utilize the loan feature.

However, it is important to explore your options before deciding on a Solo 401(k) provider, since many plans do not allow loans. IRA Financial Group is one of the few providers that allows for the loan option in its Solo 401(k) plan.

Learn More: Jobs Anyone Can do to Quality for a Solo 401(k)

Paying Back a 401(k) Loan

Paying back your 401(k) loan is another thing to consider when borrowing funds for your plan. It is a straight-line loan, so it is principal, and interest combined.

However, if you want to use those funds to pay for a principal residence, you may be able to extend the loan past five years. So, if you are using your 401(k) to pay for a primary residence, you have some flexibility.

If you use your 401(k) loan for anything else, it is unlikely you will be able to extend the loan beyond the five years. In most cases, the loan must be paid off within that time-frame.

Taxable Distributions

You may or may not be able to take a taxable distribution from your 401(k) plan. If you are under 59 ½ and do not have a triggering event, you may not be able to access your retirement funds. Furthermore, if your plan does not have a 401(k) loan, you may find it difficult to assess your retirement account. However, you may be able to pursue a hardship withdrawal, depending on your circumstances. It is important to remember that even if you qualify for a hardship distribution, you still have to pay taxes on it.

If you qualify for a hardship withdrawal from your 401(k), you may have to wait a preset period before you can contribute to your plan. It is important to contact your current 401(k) provider to assess your options. However, if you do not have option to a 401(k) loan, you may need to take a taxable distribution.

Related: Common Mistakes People Make When Rolling Over Their 401(k)

Can I Take Money From my IRA?

If you have money in a traditional IRA, you can take a taxable distribution at any time. The amount of the distribution will be counted as taxable income during the year it was withdrawn. Plus, if you are under age 59 1/2, you will get hit with a 10% early distribution penalty.

But what about a Roth IRA? Distributions from a Roth are different than from a traditional, pretax IRA. Contributions made to a Roth can be withdrawn tax- and penalty-free at any time. However, income and gains generated by the investments would be subject to tax and penalties if they are not qualified.

In order to avoid taxes on the earnings, any Roth IRA you own must have been open for at least five years, and you must be at least age 59 ½. Once those conditions are met, you can withdraw any or all of your Roth IRA funds.

Therefore, it’s important to keep in mind that tapping an IRA (traditional or Roth) does come with drawbacks.

Related: Traditional IRA vs. Self-Directed IRA

What About a Solo 401(k)?

Many self-employed individuals enjoy the benefits of a Solo 401(k). Almost anyone who has self-employment income, and no employees can open a Solo 401(k). However, as previously mentioned, your plan provider may not allow for a loan. In this case, you would want to find one who does offer a loan feature. Furthermore, if you have a triggering event, such as losing your job, you can rollover your old 401(k) funds into a Solo 401(k). But again, you need self-employment income.

While this sounds challenging, in the gig economy, many people can easily find ways to make money that constitutes being self-employed. For example, driving for Uber or Door Dash are two easy examples of ways to get self-employment income that would help you qualify for a Solo 401(k) and the option to access the loan feature. Additionally, selling items through an eBay store would also constitute self-employment income. Regardless of how you go about it, there are a lot of easy ways to obtain self-employment income with today’s gig economy.

Related: Solo 401(k) Eligibility

Conclusion

Sometimes, unforeseen circumstances arise. We have all struggled with unexpected expenses from time to time. Unfortunately, 2022 may end up being a tough year for many. We have an inflation rate that has reached 40-year highs. Furthermore, stocks are down, cryptos are down, and real estate is hovering, but may face additional pressures with rising income rates.

Our economy is also continuing to suffer from supply chain issues and the effects of Russia’s War with the Ukraine. Even with all the tough circumstances plaguing both the market and economy, you may find yourself in a desperate situation. From the losses of jobs to the increased cost of everyday life, you have options.

The 401(k) loan option is far superior to a taxable distribution. Of course, your plan needs to offer it. The alternative, if you have self-employment income, is the Solo 401(k). Just remember to ensure the provider offers a loan feature.

While everyone’s situation is different, it is important to consider the options you have available during tough times.

Considering your options? Contact IRA Financial Group today to learn more about Solo 401(k) plans and a Solo 401(k) loan.

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