It’s nice to have a 401(k), but how helpful or damaging is it to dip into your retirement savings to cover an unexpected expense, to pay down a deluge of debt, or to make a major purchase?
Some people borrow from their 401(k) for those reasons and others, such as helping a family member, paying for large medical expenses, funding a business startup or going on vacation. There are pros and cons, and those considering the option need to balance long-term impacts with their immediate needs for tapping into what should be a long-term retirement savings account.
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“Most financial experts caution against borrowing from your 401k,” says Charisse Mackenzie, a financial advisor. “But they also concede that a loan may be a more appropriate alternative to an outright distribution, if the funds are absolutely needed.”
Mackenzie lists a few advantages and disadvantages of borrowing from a 401k:
- No credit check. If a person has trouble getting credit, borrowing from a 401k becomes an option because it requires no credit check. “As long as your company and its participating plan permits loans, you should be able to borrow,” Mackenzie says.
- It’s more convenient. Usually less paperwork is required when borrowing from your 401k and you receive the money quicker than with a traditional loan.
- Better interest rate. “While the rate you pay depends upon the terms your 401 (k) plan sets out, the rate is typically lower than the rate you will pay on personal loans or through a credit card,” Mackenzie says. “Plus, the interest you pay will be to yourself rather than to a finance company.”
- Opportunity cost. “One of the main drawbacks is the money you borrow will not benefit from the potentially higher returns of your 401(k) investments,” Mackenzie says. “Additionally, many people who take loans also stop contributing. This means the further loss of potential earnings and any matching contributions.”
- Potential penalties and tax consequences. A 401(k) loan not paid is deemed a distribution, subject to income taxes and a 10 percent penalty tax if you are under the age of 59 ½. “Should you switch jobs or get laid off, your 401(k) loan is required to be paid by the due date of your federal income tax return,” Mackenzie says. “If you do not have the cash to pay the balance, it will have tax consequences.”
- Less take-home pay. Most retirement plan loans are repaid as payroll deductions. “If you’re suffering financially and living paycheck-to-paycheck, a loan from your 401(k) doesn’t help you,” Mackenzie says. “If you’re squeezed further to pay monthly bills, a loan in fact could make your situation worse.”
- A red flag alert. “Borrowing from retirement savings to fund current expenditures could be a warning sign of overspending,” Mackenzie says. “You may save money by paying off your high-interest credit card balances, but if these balances get run up again, you will have done yourself more harm.”
“Much of the decision on whether to borrow from a 401(k) depends on the degree of financial difficulty people find themselves in,” Makenzie says. “They should always try to consider better alternatives first, because retirement savings are so vital.”