The Drawbacks of 401k Loans
The biggest danger of taking out a 401k loan is that it will disrupt the dollar cost averaging process. This has the potential to significantly lower long-term results. Another consideration is employment stability; if an employee quits or is terminated, the 401k loan must be repaid in full, normally within sixty days. Should the plan participant fail to meet the deadline, a default would be declared and penalty-fees and taxes assessed.
401k Hardship Withdrawal
What if your employer doesn’t offer 401k loans or you are not eligible? It may still be possible for you to access cash if the following four conditions are met (note that the government does not require employers to provide 401k hardship withdrawals, so you must check with your plan administrator):
1. The withdrawal is necessary due to an immediate and severe financial need
2. The withdrawal is necessary to satisfy that need (i.e., you can’t get the money elsewhere)
3. The amount of the loan does not exceed the amount of the need
4. You have already obtained all distributable or non-taxable loans available under your 401k plan
If these conditions are met, the funds can be withdrawn and used for one of the following five purposes:
1. A primary home purchase
2. Higher education tuition, room and board and fees for the next twelve months for you, your spouse, your dependents or children (even if they are no longer dependent upon you)
3. To prevent eviction from your home or foreclosure on your primary residence
4. Severe financial hardship
5. Tax-deductible medical expenses that are not reimbursed for you, your spouse or your dependents
All 401k hardship withdrawals are subject to taxes and the ten-percent penalty. This means that a $10,000 withdrawal can result in not only significantly less cash in your pocket (possibly as little as $6,500 or $7,500), but causes you to forgo forever the tax-deferred growth that could have been generated by those assets. 401k hardship withdrawal proceeds cannot be returned to the account once the disbursement has been made.
Non-Financial Hardship 401k Withdrawal
Although the investor must still pay taxes on non-financial hardship withdrawals, the ten-percent penalty fee is waived. There are five ways to qualify:
1. You become totally and permanently disabled
2. Your medical debts exceed 7.5 percent of your adjusted gross income
3. A court of law has ordered you to give the funds to your divorced spouse, a child, or a dependent
4. You are permanently laid off, terminated, quit, or retire early in the same year you turn 55 or later
5. You are permanently laid off, terminated, quit, or retired and have established a payment schedule of regular withdrawals in equal amounts of the rest of your expected natural life. Once the first withdrawal has been made, the investor is required to continue taking them for five years or until he/she reaches the age of 59 1/2, whichever is longer.
A 401k hardship withdrawal should be a last resort. An IRA, for example, has a lifetime withdrawal exemption of $10,000 for a house with no strings attached.
What is the maximum contribution limit on your 401k account? The answer depends on your plan, your salary, and government guidelines. In short, your contribution limit is the lower of the maximum amount your employer permits as a percentage of salary (e.g., if your employer lets you contribute 4% of your salary and you earn pre-tax $20,000, your maximum contribution limit is $800), or the government guidelines as follows:
401k Maximum Contribution Limits
2004: $13,000
2005: $14,000
2006: $15,000
Once the year 2006 has been reached, the total maximum contribution limit will be increased based on changes in the cost of living.
Catch Up Contributions
If you are fifty years or older and your employer offers “catch-up” contribution for your 401k, you are eligible to contribute additional amounts up to the maximum contribution limits as follow:
401k Maximum Catch-Up Contribution Limits
2004: $3,000
2005: $4,000
2006: $5,000
Once the year 2006 has been reached, the total maximum contribution limit will be increased based on changes in the cost of living.
A Reminder on Employer Matching Contributions and 401k Contribution Limits
Once again, employer matching contributions up to six-percent of an employee’s pre-tax salary are not included in the contribution. For example, if you qualified, you could make a 401k contribution of $13,000 in 2004 and have your employer still match the first six-percent of your salary; that match would be deposited above and beyond the $13,000 you contributed directly.