What’s the Difference between a 401(k) Loan and 401(k) Withdrawal?

Restrictions on 401(k) loans and 401(k) withdrawals have recently been loosened for investors looking to tap into their retirement savings to get by right now. 

Before making a move, it’s important to know the difference between a 401(k) loan and 401(k) withdrawal, and fully understand the consequences of dipping into your retirement savings earlier than planned.  

401(k) Withdrawal Provision Changes

 difference between 401(k) loan and 401(k) withdrawal

Before the CARES Act was signed into law on March 27, 2020, if investors wanted to withdraw from their 401(k)s, they needed to be at least 59½ years old without having to pay early withdrawal penalties to the IRS. 

These withdrawals were subject to ordinary income tax on the amount withdrawn plus a 10% early withdrawal penalty–unless the participant qualified for a hardship withdrawal. 

The CARES Act changes the hardship withdrawal definition and lessens some of the penalties for those under 59½ years old who tap into their 401(k)s. 

For those who qualify for a Coronavirus-Related Distribution (CRD) during 2020, the distribution will be treated as a safe-harbor distribution. 

Under the legislation, hardship distributions extend to the following…

  • Individuals, their spouses, and dependents who have been diagnosed with the virus.
  • Individuals who have experienced adverse financial consequences. 
  • Individuals who haven’t been able to work because they’ve had to stay home to take care of their kids.
  • Business owners who have had to slash operating hours or shut down due to the outbreak.

Here are important changes to 401(k) and 403(b) withdrawals under the CARES Act…

  • Investors are allowed to withdraw up to $100,000 of the account balance. 
  • Investors who qualify will not be subject to a 10% early withdrawal penalty.
  • While regular income taxes will be owed on the withdrawn amount, investors are allowed to spread the tax liability over 3 years to lessen the tax burden.
  • If the money is paid back into the 401(k) account within 3 years, it will be considered a rollover, and not be subject to taxes. 

[Related: What Should I Do with My 401(k) Right Now? ]

401(k) Loan Provision Changes

 difference between 401(k) loan and 401(k) withdrawal

401(k) loans are different from 401(k) withdrawals because it’s not a distribution.

A 401(k) loan must be paid back typically within 5 years, with interest, and you do not have to pay taxes on the amount borrowed. 

The CARES Act doubles the borrowing limit on a 401(k) from $50,000 or 50% of the vested account balance, up to $100,000 or 100% of the vested account balance. 

This provision allows qualified participants to take a loan from a qualified employer plan between the bill’s date of enactment, March 27, 2020, and September 23, 2020. 

You can also delay payments on the loan for up to a year–however, interest will accrue.  

Under the legislation, you are supposed to show hardship as a result of the virus

And each plan administrator will treat this differently, and some may require more documentation than others. 

Some employers do not allow you to take out a 401(k) loan at all, so check with your plan administrator to see if this is an option. 

[Related: 5 Ways to Reduce Financial Stress Right Now ]

Why You Should Avoid Tapping into Your 401(k) 

 difference between 401(k) loan and 401(k) withdrawal

If you really need money for rent and bills, we recommend you exhaust all other resources before taking out a loan or withdrawal from your 401(k). 

Even with the hardship provisions in the CARES Act, it’s advisable to not touch your retirement savings. 

 difference between 401(k) loan and 401(k) withdrawal

That’s because every dollar you pull out now means you’re losing out on the growth of that money over time

To show you how powerful compounded growth is to your future, let’s say you have $75,000 in your 401(k), and you don’t tap into your account. You are 53, and you plan on retiring at 68–or in 15 years. 

Even if you stopped contributing any more money to your 401(k) for the next 15 years, and you got 6% return on your money, that money could grow to $179,741

In this hypothetical situation, that’s almost $100,000 growth to your account balance–without you ever contributing another cent. 

Now, let’s say you are able to show hardship as a result of Covid-19 and decide to take a $25,000 penalty-free early withdrawal from your 401(k) to cover expenses right now. That would leave you with a balance of $50,000. 

Let’s say you decide not to pay it back over the course of 3 years so it’s not considered a rollover, and you did not contribute anything more to your 401(k) for the next 15 years. 

That would leave you with around $119,827, and you would have to pay taxes on the $25,000 you withdrew. 

Depending on your income needs during retirement, early withdrawals could negatively impact the type of retirement lifestyle you have. 

And, it could put you in the position where you have to work longer to make up for the money you pulled out now

Another reason to avoid tapping into your 401(k) if you need money right now is that you may be forced to sell at the wrong time–further causing you to have less money.

Even if you reinvest these funds later on, you may miss any gains investments would have made in the interim.

[Related: 7 401(k) Mistakes Every Investor Should Avoid ]

Seek Professional Help Before You Make a Move  

 difference between 401(k) loan and 401(k) withdrawal

As mentioned, it’s advisable not to tap into or borrow against your 401(k) if you can avoid it. 

Before you make a move, do yourself and your financial future a favor and reach out to a third-party expert to examine how tapping into your 401(k) may directly affect you.

In the age of low-cost robo advisors and financial DIY tools you can access on your smartphone, many people overlook the importance and value of third-party expert advice

Although you might have basic investment knowledge, consulting an expert to make the moves that require skill and care may help boost retirement savings…

Check out our no-cost guide on The Different Types of Licenses Financial Advisors Have and What They Mean to You.

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