If you need cash to buy a house or pay down debt, you may consider tapping your retirement account. Generally, taking money out of your 401(k) or pension before you retire means a big tax penalty unless you're just borrowing the money. The IRS allows you to take loans from certain types of retirement plans, with a few restrictions. Before you borrow against your nest egg, you need to understand how retirement loans work.
Generally, the IRS lets you borrow money from qualified retirement plans that fall under section 401(a), 403(a) and 403(b) of the Internal Revenue Code. This includes defined benefit pension plans, 401(k) plans, 403(b) accounts, 457 plans and the federal Thrift Savings Plan. You can't take a loan from a traditional or Roth IRA or an IRA-based plan, like a Simplified Employee Pension or SIMPLE IRA. If you're enrolled in a qualified plan, find out whether loans are allowed and whether there are any other eligibility requirements. For example, you may only be able to take out a loan once you've been at your job for a specific length of time.
If your retirement plan allows loans, be aware of the limits on how much you can borrow. As of 2013, the IRS limits retirement loans to $50,000. The limit goes up to $100,000 for victims of Hurricanes Katrina, Rita and Wilma. If your total account balance is less than the maximum limit, you can borrow up to 50 percent of your vested benefits or $10,000, whichever is greater. You can take out more than one loan at a time, but the total amount you borrow can't be more than the maximum limit allowed.
Repaying the Loan
If you qualify for a retirement loan, you'll have five years to pay it back. You can get a longer loan term if you're using the money to buy a house and you can suspend your payments if you take a leave of absence. If you don't pay the money back before the five years is up, the loan gets treated as a distribution for tax purposes. This means you'll have to pay income taxes on some or all of the money. Generally, distributions from defined benefit pensions are fully taxable. If you borrowed money from a plan that you funded with after-tax dollars, the distribution is only partially taxable. The IRS will also expect you to cough up a 10 percent early withdrawal penalty if you're under age 59 1/2.
If you need the money in your retirement account because of a financial crisis, you may be able to get a hardship distribution instead of a loan. Generally, the IRS allows hardship distributions from plans that you contributed money to, such as a 401(k) or 403(b). You must be able to demonstrate an immediate financial need, and you can take out the money you put in only through elective deferrals. Examples of financial need include unexpected medical expenses, funeral expenses or payments to avoid eviction or foreclosure. You don't have to pay back a hardship distribution, but you'll still have to pay taxes on the money.
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