The money you set aside in your 401k is meant to be saved for retirement. That’s why there are so many rules and tax penalties surrounding early withdrawals from this account – to protect your future self from your present-day self! Many financial advisors will tell you that borrowing against your 401k retirement account is a bad idea. However, there are certain circumstances in which you might want to consider temporarily borrowing from your 401k.
What does it mean to Borrow Against a Retirement Account?
Taking out a 401k loan means borrowing from your own money that you have already set aside for use in retirement. Depending on your employer and the specifics of your 401k plan, you are generally allowed to borrow the lesser of $50,000 and half of the retirement account balance
If you do not have a traditional 401k plan through your employer, you may set up an Individual Retirement Account (IRA). There are several types of IRAs, both pre-tax and post-tax, but all are tax-sheltered (meaning that you will not pay taxes on your earnings through the account). It is best to speak with a financial advisor regarding which account is best for you, as well as the pros and cons of borrowing against your specific account.
What are the Pros?
Generally, the interest rates on 401k loans are lower than the interest on most personal loans and certainly on credit cards. Additionally, there is typically no credit check required to obtain this type of loan and it leaves little or no effect on your credit score. Usually, you can get the loan very quickly (within a few days) the process is simple and straightforward.
What are the Cons?
First of all, borrowing money from your retirement account means depleting the funds that would otherwise grow and increase with the market over time. Even if you pay the loan back fully, the years that money is out of the market means a lost opportunity for growth, which could potentially result in substantial amounts of lost funds over time.
Second, taking out a loan doesn’t solve the underlying financial problem that caused you to need the loan in the first place. It is a temporary solution and unless you have a plan to pay back the debt, it is not a long-term strategy. The less immediate, but more lasting, approach is to discern how you got into financial trouble, to seek out a different type of loan (low-interest if possible) and work hard to change your habits to avoid similar future pitfalls.
Additionally, unlike most forms of consumer debt, a 401k loan is not forgiven in a bankruptcy filing. In other words, if you cannot repay the loan, it is considered a withdrawal from your retirement account and you may find yourself owing both taxes and a penalty on the money you’ve withdrawn.
Perhaps the biggest risk of all is that most 401k loans are tied to your employer: If you leave or lose your job, your loan balance will become due very soon after, usually within 60-90 days. If you are unable to pay it back within this time, the outstanding balance is both taxed and subject to a 10% penalty.
When should You Borrow Against a Retirement Account?
One situation where people consider borrowing against a retirement account is to pay off large credit card bills or other high-interest debts. If your 401k loan has a much lower interest rate than the high-interest rate debt and you have a plan in place to pay back the loan, this could be a viable option.
A section situation is an emergency. While the best practice is to build a dedicated emergency fund (in cash or easily accessible money), sometimes this is not feasible or you might have just used up your money in your emergency fund for something else. If you do not have enough money saved in an emergency account to cover an emergency, a 401k loan could be used in this instance. Like paying off your credit card debt, it is imperative that you have a plan in place to pay back the loan or else the debt will continue to accrue.
Assuming you have exhausted all of your other immediate options, such as using savings to pay off a debt or cutting back on expenses and putting that money towards your debt, before you consider borrowing against your retirement account you should consider other options that don’t put your retirement future in jeopardy.
Consider working with a debt relief company to determine what debt relief options are available to you. Debt consolidation is one good option, where multiple loans are consolidated into one loan with a lower interest rate. Another possible option is debt settlement, where a debt settlement company can negotiate with your creditors on your behalf to accept a lower amount than you owe to settle all of your debts.
What should You Do?
Taking your financial situation as a whole, you might still be torn as to whether borrowing against your retirement account is a good idea. Keep in mind that you should only take out one of these loans if you have a plan to pay back that loan and not continue the cycle of debt further. If you need additional resources, reaching out to a debt relief company to discuss all of the possibilities for your particular situation is your best option.