401(k) Loan vs. IRA Withdrawal

October 14, 2018 — 10:29 PM EDT

Dipping into a retirement account early is rarely an investor’s Plan A. But there could come a time when an individual sorely needs cash and has no other options. Under certain circumstances, drawing on a 401(k) or IRA might be your only real choice.

Certainly, the IRS doesn’t make it easy to tap these tax-advantaged accounts. Even if you qualify for a so-called hardship withdrawal, you’ll be assessed an extra 10% penalty on any funds you take out of a traditional 401(k) or IRA account before the age of 59½. That’s on top of the ordinary income tax rate you normally pay on distributions. This rather strong deterrent is designed to keep Americans from tapping their funds ahead of schedule.

There is one exception: You can withdraw the post-tax money you've invested in a Roth IRA without being assessed a 10% penalty as long as you are careful to withdraw only the amount you put in, not any earnings it made. (See How to Use Your Roth IRA as an Emergency Fund for details.)

But even with 401(k) accounts and traditional IRAs, the tax code does provide some ways around the 10% early distribution fee. Granted, the decision to use this money for something other than your retirement is one that shouldn’t be taken lightly. But if you can get around the IRS penalty, the idea starts to make a little more sense.

Borrowing From Your 401(k)

For many workers, this is probably the easiest way to access retirement money early. Some plans allow you to borrow from your 401(k) for a wide variety of reasons.  

With a 401(k) loan, you can withdraw up to $50,000 (or half the vested balance in your account, if it’s less than that). You then repay your account over a period of up to five years (some employers allow a longer repayment period if you borrowed to buy a home). Also, some plans allow the borrower to reimburse the account early with no prepayment penalty

It’s worth noting that you typically pay back a little more than you took out of the account. This “interest” actually works to the borrower’s advantage. Because the funds go into your account, you’re essentially making up for some of the interest or capital gains the money would have accrued had you not withdrawn it from the fund. And most 401(k) plan providers and platforms will charge fees to process and service a loan. This adds to the cost of borrowing and repayment.

But here’s the kicker: Your employer may not offer these loans. Your odds of getting one are better if you work for a large company, many of which now include 401(k) loans as part of their retirement packages. 

Even if your company gives you this option, experts say you should only consider it if you need the money for a true financial emergency. One risk of borrowing from yourself is that if you're terminated or leave your job, you may have to pay back the loan in as little as 60 days -- at the same time you find yourself in a vulnerable financial situation. Otherwise, the funds are considered an early withdrawal and trigger the 10% penalty. An outstanding 401(k) loan could also leave you trapped in a job for the same reason, as leaving for a better position could trigger the same results.

In general, there are several specific situations where 401(k) loans should be avoided if at all possible:

  • You're nearing retirement.
  • You're behind in saving for retirement.
  • Your job security may be in jeopardy.
  • You plan to quit your job in the near future.
  • You can tap other sources for the money you need.
  • You feel that repaying the loan will cause financial hardship. 

Taking a 401(k) loan in any of these situations can lead to a financial train wreck. Whether the result is a retirement shortfall and a diminished quality of life or being hit with taxes and penalties for which you are unprepared, it is especially important to avoid a 401(k) loan under the circumstances listed above.

“Many people believe that by borrowing, they just pay the money back to themselves with interest. No taxes and no penalties. That is not accurate,” says Michael Mezheritskiy, president of Milestone Asset Management Group in Avon, Conn. “When you borrow from your 401(k), you make repayments with after-tax money. However, as soon as the repayments are deposited back into your 401(k), they become tax-deferred again. When you retire and take that money out for income purposes, you will be taxed on it again. Hence it’s double taxation.”

Making Special Expenditures From Your Traditional IRA

Though traditional IRA accounts don’t allow loans, they do come with certain perks that even a 401(k) doesn’t offer. The government offers penalty-free IRA distributions, for example, for those who want to further their education or buy their first home.

The tuition exemption applies to individuals who use retirement money to pay tuition at an IRS-approved college, as well as for books and supplies. If you take enough credits, you can use the funds for room and board without penalty, too. You can even use the distribution to pay education expenses for your spouse, child or grandchild without worrying about the extra 10% hit. (See also: Pay for a College Education With Retirement Funds.)

The tax code also allows you to use $10,000 of IRA funds to pay for a first home. If your spouse also has an individual retirement account, that means you can access up to $20,000 for a down payment and closing costs.

Don’t forget, though, that unlike a 401(k) loan, there’s no requirement to build your account back up. That means you’ll need extra discipline to replenish your nest egg. If you don’t think you can do it, think long and hard before pulling money out of your IRA.  

Annuitizing Your IRA

One of the lesser-known ways to access a traditional IRA is by setting up "substantially equal periodic payments," or SEPPs. When you establish a SEPP, you make one or more withdrawals a year for either a five-year period or until you hit age 59½, whichever is longer.

The tax code actually allows any of three different calculation methods to determine the amount of your payments, so it doesn’t hurt to consult a financial advisor about your options.

While SEPPs allow you to avoid the 10% early withdrawal penalty, you’re still responsible for paying your ordinary income tax rate on the distributions.

The Bottom Line

You probably shouldn’t take money out of a retirement account early unless you’ve exhausted all other options, such as borrowing from a bank or family member. But if you absolutely must, it’s always better to find a way that avoids a big penalty from the government.

“While we prefer to see a different strategy for saving for special goals such as education or a down payment or remodel on a home, sometimes, in an emergency, the 401(k) plan loan can be a lifesaver,” says Charlotte A. Dougherty, CFP®, founder of Dougherty & Associates in Cincinnati, Ohio.

The 401(k) loan's requirement to pay back your account may be a useful prod to ensure that you replenish your funds, but it also is a risk should you lose your job. And, of course, if you have both types of retirement funds, investigate where you have the most available money or which vehicle has the lower return on your funds.

For more information, see How Much Are Taxes on an IRA Withdrawal?