Borrowing From Your 401(k): Loans vs. Withdrawals

401(k) loan

Although it is not recommended, sometimes we find it necessary to borrow from our 401(k) savings in order to cover unexpected expenses or hardships. Doing so comes with tax penalties and it is important to understand your options before tapping into these funds. 

401(k) Loans 

A 401(k) loan allows you to borrow money from your retirement savings. Typically, the maximum amount that can be borrowed is 50% of the account balance, up to $50,000 in a 12-month period. However, since 401(k) accounts are distributed through employers, each plan can come with different rules and limitations.  

Since this option is considered a loan, the funds will need to be returned to the account, usually within 5 years. This also means that no taxes or penalties will need to be paid on the loan because the borrower is expected to return the money. Borrowers should keep in mind that this option does come at a price, as the loan will require paying interest. On a positive note, the interest paid goes back into the account.  

Some borrowers may wonder what happens if you miss a payment or even default on the loan. The good news is your credit score will not be impacted. The only exception to this is if you leave your current job. Since a 401(k) account is an employment perk, the benefits are withdrawn once you are separated from the employer. Sometimes, borrowers are required to repay the loan within a short period of time after termination, and failure to do so can result in not only a defaulted loan but taxes and penalties.  

401(k) Withdrawals 

In some cases of hardship, you may be able to qualify for a 401(k) withdrawal. Some examples of hardship that the IRS deem a 401(k) withdrawal an acceptable form of financial relief are: 

  • Medical expenses 
  • Foreclosure 
  • Tuition payments 
  • Funeral expenses 
  • Purchase or repair of primary residence 

Although borrowers are not required to pay back these funds, you will be charged a 10% early withdrawal penalty. In addition, the amount you withdraw will also be taxed as regular income.  

Tax Debt Relief for 401(k) Account Holders 

Taking a loan or withdrawal from your 401(k) should not be your first choice for immediate funds. Instead, borrowers can look into using their HSA savings for medical expenses and regular savings and emergency funds for other expenses.  

Optima Tax Relief can help with your tax debt needs. Give us a call at 800-536-0734 for a free consultation today. 

Download the Optima Tax App to analyze your IRS notice instantly. 

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IRA Hardship Withdrawal: Everything You Need to Know

If you’re facing financial hard times, your retirement funds begin to look like a good source of much-needed cash. In cases of dire emergency, you may indeed be able to make withdrawals from those funds before you reach retirement age. However, the potential short-term and long-term consequences can be severe. Nonetheless, if you must make an early withdrawal from an Individual Retirement Account (IRA) or 401(k), there are certain circumstances under which you can minimize the bite by Uncle Sam.

The COVID-19 pandemic and the 2020 CARES Act have made it easier for taxpayers to withdraw funds from their retirement accounts. Learn more about taking a CARES Act retirement withdrawal HERE.

3 Types of Retirement Funds

There are three primary types of tax-optimized retirement funds in the United States:

  • Traditional IRAs
  • Roth IRAs
  • 401(k)s

Traditional IRAs

Traditional IRAs are drawn from pre-tax earnings. When you deposit funds in a traditional IRA, the taxes on those funds and your earnings are deferred until after you retire, presumably when your income is lower and you qualify for a lower tax bracket.

Roth IRAs

By contrast, Roth IRAs are drawn from post-tax earnings. Because you pay taxes on Roth IRA deposits upfront, you do not have to pay taxes on either the principal or the earnings, provided that your Roth IRA has been open for five years or longer and you are at least 59 ½ years old when you begin making withdrawals.


401(k) funds are sponsored by your employer. You can invest either pre-tax earnings or post-tax earnings, with tax implications similar to those for a traditional or a Roth IRA. Many employers match their employees’ contributions dollar for dollar. The catch is that you can’t access your employer’s contributions to your 401 (k) until you are fully vested in the company, which translates to being employed for a certain length of time which varies but five years is common.

For what reasons can you withdraw from an IRA without penalty?

If you are younger than age 59½, taking withdrawals from either a traditional or Roth IRA or from a 401(k) will usually trigger a 10 percent tax penalty in addition to paying any income taxes that are due. However, there are exceptions that vary depending on whether you are withdrawing from a traditional or a Roth IRA or from a 401 (k). You can avoid tax penalties from withdrawing from a traditional IRA even if you are younger than age 59 ½ for the following reasons

  • Purchasing a first home.
  • Educational expenses for yourself or a family member.
  • Death or disability of a family member.
  • Covering unreimbursed medical expenses.
  • Purchasing health insurance coverage (only if you are not already covered).

To claim one of these exceptions, you will need to complete IRS Form 5329 along with your income tax returns the following year. Even if you avoid the penalty, you will still need to pay taxes on the money you withdraw. This means that you should withdraw enough to cover your needs, plus a little extra for taxes.

Is there a Roth IRA withdrawal penalty?

Yes, penalty-free early withdrawals for Roth IRAs apply to only two circumstances: first–time home purchase or death or disability of a family member. However, the penalty for early withdrawal from a Roth IRA only applies to earnings, since you have already paid taxes on the principal. You will also need to submit Form 5329 along with your tax return.

How do I avoid an early withdrawal penalty on 401(k) retirement funds?

It is possible to make early withdrawals from a 401(k). However, the IRS is especially harsh on early withdrawals from 401 (k) funds. You may make what are known as hardship withdrawals before age 59 ½ for the following reasons:

  • Purchase a first home.
  • Pay for college for yourself or a dependent.
  • Prevent foreclosure or eviction from your home.
  • Cover unreimbursed medical expenses for yourself or a dependent.

However, hardship withdrawals from a 401 (k) differ from hardship withdrawals from an IRA. You will be assessed a 10 percent penalty in addition to paying income taxes on your withdrawal. To avoid the 10 percent penalty on early withdrawals from a 401(k), you must fulfill one of the following circumstances.

  • Total disability.
  • Medical expenses that total more than 7.5 percent of your adjusted gross income (AGI).
  • Court order to give the money to a divorced spouse, child, or other dependents.
  • Permanent separation from your job (including voluntary termination) during or after the year you turn 55.
  • Permanent separation at any age with a plan for equal yearly distributions of your 401(k) (once you begin taking distributions, you must continue them until you reach age 59 ½ or for five years, whichever is longer).

A better option than a hardship withdrawal from your 401(k) may be to take a loan against the value of your 401(k) with an outside lender. The lender places a lien against your 401(k) which remains in place until you repay the loan. Your funds remain in your 401(k), safe from the reach of Uncle Sam. However, if you default on the loan, the lender will have the right to seize your 401(k) to collect payment.

Is it bad to withdraw from an IRA?

It should be clear that IRA and 401k withdrawal should be considered a last resort. Even if you avoid tax penalties, you are depleting the available funds available for your retirement so in this sense, it is a bad idea and if you can avoid it, you should. If you must borrow, borrow enough to cover your obligations plus taxes, and repay the funds as quickly as possible. After all, you are actually repaying yourself – and your future.

Need to speak with a licensed tax professional? Optima Tax Relief provides a comprehensive range of tax relief services. Schedule a consultation with one of our professionals today.

Can Retirement Contributions Impact your Tax Bill?

Optima Tax Relief provides assistance to individuals struggling with unmanageable IRS tax burdens. To assess your tax situation and determine if you qualify for tax relief, contact us for a free consultation.

tax form with calculator, money and pen

In these economic times, it is vital that employees contribute to their retirement plan in order to ensure that they have additional funds available to them once they decide to officially retire from the workforce. It is also important for taxpayers to understand the tax implications that come with having a retirement plan and what you should know moving forward to avoid owing a tax balance at the end of the tax year. 

What is my contribution limit? In most cases, taxpayers are able to deduct up to $6,000 for a traditional IRA. If you are 50 years or older, you are able to deduct $7,000. If you have a different retirement account, the amount will differ based on your age and type of plan you have chosen. Your contribution amount may also be limited based on the amount of income you earn.

Will I have to pay taxes on any employer contributions that are made to my retirement plan? Typically, taxpayers will not have to include qualified employer contributions to their traditional retirement plan unless they withdraw the money.

Can contributing to an IRA change my tax bracket? Contributing to your retirement plan can change the tax bracket you are typically in, if your income is near a bracket level. It is important to know that contributing to your plan does not have as big of an effect on your income bracket as you may think because each level of your income is taxed at the income tax rate for that bracket. 

How much should I contribute to my retirement plan? This answer for this question will vary per individual. Many tax professionals recommend that you save 10-20 percent of your income throughout your working life. Some things to also keep in mind when determining how much you should contribute are:

  • How close are you to retirement? 
  • How much disposable income do you have left after your expenses?
  • What is your current income?

When can I make retirement plan contributions? This will depend on the type of retirement plan you have. If you have an IRA, you can contribute up to the original due date of your tax return.  You can also make contributions to your 401(k) plan or 403(b) plan until December 31 of the tax year.

If you need tax help, contact us for a free consultation.

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Are Social Security Benefits Taxable?

Under the laws that are presently in place, you may begin to collect Social Security as early as age 62. But if you begin collecting benefits early, your monthly benefit amount will be less than what you would collect if you wait until your full retirement age, which may fall anywhere from age 65 to age 67.

If you have additional income, you may be liable for federal income taxes on your Social Security payments. And if you owe back taxes, Uncle Sam may take a bite out of your benefits as well.

Is Social Security Your Only Income?

If Social Security payments represent your sole source of income, in all likelihood you won’t have to pay federal income taxes on your benefits, unless you are married and file federal income tax returns separately from your spouse. This is because the IRS has established what it calls a base income for Social Security benefits that is exempt from taxes. As a result, unless you earned a very high income while you were working (and are therefore entitled to very large Social Security benefits), the amount that you receive from Social Security alone will probably fall below the tax-exempt base amount. 

Calculating Your Combined Income

To determine your base income, you must perform some simple calculations. First, add half of your total annual Social Security benefits to any other income you received for the previous year. Include tax exempt income and any other income normally excluded from taxation.Compare the total to the base amount (listed below) for the tax filing status that applies to you. If the total is larger than the base amount, you may be subject to federal income taxes for at least part of your Social Security benefits.

Your Base Income

The amount of Social Security benefits that the IRS exempts from taxation depends on your marital status and your total annual gross income. For 2014, the base amounts of tax-free income for Social Security recipients are listed below:

  • Married Filing Jointly:$32,000
  • Single, Head of Household, Qualifying Widow(er) with a dependent child or Married Filing Separately (not living with spouses at any time during the previous year):$25,000
  • Married Filing Separately (living with spouses anytime during the previous year): $0

How Much of Your Social Security Benefits are Taxable?

Even if your income is more than the base amount set by the IRS for your filing status, you won’t have to pay taxes on all of your earnings. Instead, the IRS has established a formula to determine what percentage of your benefits is taxable, based on your income and tax filing status. The formula for 2014 federal income tax returns is described below:

Single, Head of Household or Qualifying Widower:

  • Income between $25,000 and $34,000: up to 50 percent of benefits are taxable
  • Income more than $34,000: up to 85 percent of your benefits may be taxable

Married Filing Jointly:

  • Income between $32,000 and $44,000: up to 50 percent of benefits are taxable
  • Income more than $44,000: up to 85 percent of benefits are taxable

Married Filing Separately: Up to 85 percent of benefits are taxable

Do You Owe Back Taxes?

The Federal Payment Levy Program (FPLP) allows the IRS to seize up to 15 percent of your Social Security benefits to satisfy a tax levy. Lump sum death benefits, Supplemental Security Income (SSI) benefits and benefits paid to children are also exempt from seizure under the FPLP. In addition, taxpayers with incomes that fall below poverty levels set by the Department of Health and Human Services may also be exempt from seizure of their Social Security benefits.

How to Reduce Your Potential Tax Bite

If your circumstances indicate that you will probably be subject to federal income taxes on at least part of your Social Security benefits, do not despair. Even if you are married and file your federal income tax returns separately from your spouse, you will not have to pay 100 percent of your Social Security benefits back to the federal government. Instead, you will be obliged to include all of your Social Security benefits along with any reported income from part-time earnings or investments. 

But the income that you report from your Social Security benefits is entitled to deductions and tax credits just like any other income. Therefore, your final federal income tax obligation may be minimal. Regardless of your circumstances, it is worthwhile to investigate any and all legitimate tax breaks, either on your own or with the assistance of a tax professional.