Are you unsure whether you should request a participant loan or an early 401(k) withdrawal? More than thirty-three million Americans filed unemployment claims in seven weeks, and the U.S. unemployment rate is near great depression-like at nearly 15 percent. With so many Americans out of work, an increase in participant loans and 401(k) withdrawals are inevitable.
Americans who had been laid-off or furloughed can request an early withdrawal from their 401(k) administrator, and those Americans who are fortunate enough to have a job still can request either a participant loan or an early withdrawal from their retirement account.
The government through the passing of the Coronavirus Aid, Relief, and Economic Security (CARES) Act muddy the water a bit more because you can now withdraw up to $100,000 from your tax-deferred retirement account (s) without incurring the 10 percent early withdrawal tax penalty, which usually applies to early distributions for individuals under 59 ½ years old. Moreover, since you are withdrawing from a tax-deferred retirement account, the government will let you spread the tax liability over three years.
Participant Loan
Most retirement plans allow you to request a participant loan, which is a self-loan. You can borrow up to $100,000 of your vested account balance. The Coronavirus Aid, Relief, and Economic Security (CARES) Act increases the amount you can borrow from your profit-sharing, money purchase, 401(k), 403(b), and 457(b) to $100,000 from $50,000 or 50% of your vested balance.
The participant loan comes with the terms of all other loans, including maturity date, interest rate, and fees. You should reach out to the plan administrator and probe them on the charges that come with the loan before you apply. Interest rate is often prime rate plus two percent, and the loan’s term is always five years. The current prime rate is 3.25%. You can get the loan initiation fee either from the plan sponsor (your employer) or the plan administrator.
If you were to get a $100,000 participant loan from your retirement plan, your monthly payment for the next five years would be $1,899. Your total payment plus interest would be $113,913—the $13,916 in total interest paid back to you.
If you default on the loan, quit your job, or exceed the maturity, your employer will treat the loan as an early withdrawal, and you will absorb the 10 percent early withdrawal tax penalty and the standard tax liability. If you are already financially stressed, a $1,899 monthly payment could deteriorate your finance budget further.
Early 401(k) Withdrawal
Before the CARES Act eliminates the 10 percent early withdrawal tax penalty, which usually applies to early distributions for individuals under 59 ½ years old, and spreads the tax liability over three years, an early 401(k) withdrawal was a terrible financial transaction.
If you fall in the 24% federal tax bracket and you withdraw $100,000 from your retirement, your tax liability will be $24,000. Because the CARES Act allows you to spread that tax liability over three years, your tax liability on that transaction for the next three years will be $8,000 ($24,000/3). Before the CARES Act, your tax liability on that transaction for next year would be $34,000 ($100,00 x 10% early withdrawal penalty) plus ($100,000 x 24% your tax bracket).
Participant Loan or Early 401(k) Withdrawal
Participant loan is the best financial option between the two because the loan initiation or processing fee is often a few basis points off the loan, and the interest charges are paid to you. However, with 33 million Americans unemployed, an early 401(k) withdrawal makes better financial sense right now.