Should you take a loan out from your 401k, or do a hardship withdrawal?
The answers are next. Hello, this is Jeff Bowers, Certified Financial Planner with Plan 2 Retire. In today's video, we're going to talk about should you take a loan from your 401k, or take a hardship withdrawal from your 401k? Then, we're going to talk about the reasons maybe why you should, some of the details about how they work, and then maybe some alternatives. First off, 401k loans, whether your plan allows 401k loans or not is something you need to investigate. Not all 401k plans allow 401k loans, some do, some don't. The way you can find out is to review your plan's summary plan description. It'll describe if 401k plan loans are available. Some plans allow one loan, some allow two loans, but that's something you would need to research.
If your plan does allow plan loans, here's some considerations for you to think about. Not only are you going to have the additional interest cost of the loan, of course, that interest is going back into your account, so in essence you're paying yourself back with that interest. But what people often forget is the opportunity costs of those payments. Because what we find from our experience, when an employee takes a loan from their 401k, many times they stop their contributions into the 401k, because they cannot afford to pay the loan back, and continue to make contributions.
So, let's use an example. If you take an employee, age 40, wants to withdraw or take a $20,000 401K loan. That payment over five years is going to be about $368 a month. If they stopped their contributions, and are not able to start them again until they're 45, by the time they're 67 they're actually going to have $91,000 less in their 401k plan, because they missed those five years’ worth of contributions. That's a pretty substantial dollar amount that they would be losing. So remember, the cost of a 401k loan or more than just the loan itself. It's often the funds that you lose that you would have gained in your account, because you're not making the contributions.
Secondly, hardship withdrawals. Again, whether hardship withdrawals are allowed in your plan is something that you need to research. Your summary plan description will describe if hardship withdrawals are allowed. Some are, some aren't. Now, if there are hardship withdrawals allowed, the IRS has certain guidelines. There are certain things that allow you to qualify for a hardship withdrawal. Generally, there's six categories, things like foreclosure, or eviction from your home, adverse medical expense, job loss, et cetera, and these are things that the IRS has clearly defined. Now, if you do take a hardship withdrawal, remember that money is still taxed. But what about the cost on the same thing on an opportunity costs on a hardship withdrawal?
Let's take the same person. Let's take an employee age 40, who decides to do a $15,000 hardship withdrawal out of their 401k plan. By the time that employee is age 70, that $15,000 would have been worth $120,000, if they get a 7% return on their investment. So they're not really giving up $15,000 out of their plan, they're giving up the future opportunity costs of $120,000 at age 70, a substantial amount of money. So as an alternative, here's a couple of steps that I suggest you pursue.
From my experience. When you need a loan or a hardship withdrawal, it's usually a difficult financial circumstance. I get that, and I understand that people get in difficult times. And we're certainly not being judgemental here, but here's some things you should consider. First you should look at is what is your cashflow in your house? What are the amount of expenses? What's the amount of income? If your expenses are more than your income, the loan or the hardship withdrawal is not going to necessarily make you long term any better. So you might experience a temporary band aid approach. So the first thing you need to do is to make sure you get your household expenses lined up that you're living within your means.
Second thing to consider is possibly part-time work, or pickup up overtime at work, or look for other opportunities to sell some things around your home, and maybe get the value instead of taking a loan or hardship withdrawal that's only going to damage you in the long run. The last thing to consider, decisions like this are something that should not be made in a vacuum. What I mean by that is you should have some sort of idea of are you on track for your retirement? Are you on track that you can afford to take this kind of hit on your value, and your 401K down the line? The only way you're going to do that is to do some good retirement income planning.
Down in our description, I'm going to include a link to our financial planning tool. I strongly suggest you click that and go through the exercise. We'll be glad to help you out with that, and give you some ideas, and some action steps that you can take that maybe you can avoid the loan, avoid the hardship withdrawal. Lastly, down in the description is also a link that if you want to have a phone call with me, if you want to discuss your particular circumstances, let's talk about it, and see if there's a way we can help. Also, if you want additional information and videos like this in the future, hit that Subscribe button here on YouTube. We put content out like this on a regular basis, and if you need additional information and disclosures, go to our website plan2retire.com. Thank you and appreciate your time today.