If you’ve thought about borrowing from your 401(k), you should pause a moment before you transition from thinking to acting. Your 401(k) is a nest egg, growing tax-free, that you build up over your working life to provide you with money after retirement. When it comes to financial decisions, a loan from a 401(k) usually qualifies as a last resort.
What are some possible alternatives?
Before turning to your 401(k) for capital, consider some less extreme courses of action. Alternatives worth exploring include:
- Applying for a personal loan. It does involve taking on debt, but you don’t have the additional concern of tax penalties for withdrawing 401(k) funds early or the anxiety of borrowing against your retirement savings.
- Negotiating with your creditors. If the interested parties can agree to a get-out-of-debt plan, borrowing from a 401(k) may not be necessary.
- Applying for a home equity loan or home equity line of credit (HELOC). If you’re far enough past the break-even point on your mortgage, leveraging your home equity could provide access to some emergency capital.
- Tapping into your emergency fund, if you have one. It doesn’t really count as a desperate measure when you’ve planned for just this kind of situation.
Scenarios for a 401(k) loan
Despite the drawbacks, there are a few legitimate reasons to borrow from your 401(k). Just remember to proceed with caution.
1. Borrowing from a 401(k) is your only option
Many, if not most, financial planners advise against taking out a loan from a 401(k). Their opposition generally boils down to the fact that a large 401(k) loan could affect your ability to enjoy a comfortable retirement.
If you haven’t been saving enough for retirement in the first place, drawing out of a 401(k) will probably just compound the problem. To get an idea of where you stand on retirement savings, use the Bankrate 401(k) Loan Calculator.
2. A loan from a 401 (k) is the lowest-cost option
If you’ve experienced a big financial setback — declaring bankruptcy, for example — the ensuing drop in your credit score could make it difficult to get credit at affordable rates. In cases where a lower credit score leads to interest rates 2-4 percent higher than normal, 401(k) loans could provide a less expensive option.
Just remember that the interest you save by choosing a 401(k) loan over a bank loan still might not offset the loss of earnings from taking the money out. You could also face a penalty tax for using the funds.
3. Your job status is secure — really secure
Before borrowing from a 401(k), make sure that you feel good about your employment situation. If you leave your job (or lose it), you’ll typically have to repay the loan balance within 60 days. Plus, the IRS will label the money you took out as an early withdrawal, which means you’ll be hit with a 10 percent penalty and owe income taxes on the amount.
Also, consider your projected income over the course of the normal five-year loan repayment period. Payments on a loan from a 401(k) are usually taken directly out of your paycheck — on an after-tax basis — so you’ll want to be sure you can live without that money from your take-home pay.
4. You’re using the money for a smart investment
Under certain circumstances, borrowing from a 401(k) to buy a home or advance your education might be worth considering. For homebuyers, the repayment period is often extended. In the case of education, it means an investment in yourself. If it leads to higher earnings, you’ll be able to save more for your retirement.
Just make sure the investment — a house, an advanced degree, what have you — is as close as possible to a can’t-miss proposition.
When do you need money the most?
It can be difficult to focus on tomorrow when you face financial pressures today. Borrowing from a 401(k) may seem like the option with the fewest question marks.
Just appreciate the seriousness of the decision. After all, you’ll need your retirement savings most when your prime wage-earning days are behind you.
If you’re interested in supplementing your 401(k) with a CD or money market account, check out banking information and resources from Bankrate.