Saving regularly in a 401(k) account and leaving it untouched is a great way to build your nest egg. That said, unforeseen situations happen to all of us at some point in our lives. If you’re desperate for cash and your emergency fund isn’t enough to cover your expenses, you can borrow against your 401(k). Here’s when a 401(k) loan makes sense – and how to do it.
How to Borrow From Your 401(k)
A 401(k) loan is not the same as an early withdrawal, which is subject to both income tax and a 10% early-withdrawal penalty if you’re under age 59.5. By contrast, a 401(k) loan is just that: a loan. As you long as you pay it back, it’s not subject to taxes or penalties.
Borrowing from your 401(k) is actually a much easier process than applying for other types of loans. There is no application or credit check to worry about. The first step will be to reach out to your HR department to confirm that your plan actually allows for loans. Some employers choose to limit what you can spend your loan on to things like education or medical bills, so you may need to discuss your intentions for the money before you can receive it. You’ll also only be able to borrow the lower of $50,000 or 50% of your total vested balance.
Once you discuss the terms of your loan and the amount you’d like with your HR department and everything goes well, you should receive a check with your loan amount. Most plans require the loan be paid in full, with interest, within five years. Your employer will accept repayment by diverting money from your paycheck. The interest you pay will also be deposited into your 401(k) account, so it’s really like you’re paying yourself interest. The downside is that this interest is paid with after-tax dollars, which means that it’s a 401(k) contribution that doesn’t benefit from the usual pre-tax treatment.
Not a First Option
A 401(k) loan shouldn’t be the first place you look for extra money. The money in this account is earmarked for retirement, and borrowing from it runs the risk of headaches down the line. While any interest you pay on the loan is paid back into the account, you also have to consider the opportunity cost of missing out on market returns while the money is absent from the account. You also run the risk of having to pay income taxes and withdrawal penalties if you’re unable to pay it back within five years or before leaving your job.
There are other downsides, too. Some companies won’t make employer matching contributions to employees who have taken 401(k) loans. Many don’t allow you to contribute to your 401(k) while you have an outstanding loan.
That said, if you have no family members to borrow from, or any home equity to borrow against, you may not have any other options. Here are a few scenarios where it makes sense.
When It’s The Least Expensive Option
If you’re trying to take out a loan for a major purchase, a bank loan can come with a hefty interest rate. If taking a small loan against your 401(k) will save you a significant amount of money with a lower interest rate, then you may want to consider the loan.
One such scenario is buying a home. If you don’t have enough cash on hand to cover the down payment, you can use a loan from your 401(k) to help pay the down payment. As with any decision between investing and buying a home, you should take into account the difference between expected market returns and appreciation of your home value.
If you are concerned about paying off debt, there are steps to take before you borrow against your 401(k). Try negotiating with credit card companies. Simply asking for options can often make your creditors willing to work with you. This can get your debt under control without having to dip into your retirement funds.
When You’re Advancing Your Education
Using the loan to further your education is another investment. Just like the house purchase, it’s the investment in the future, which should hopefully pay back whatever return you may have lost by taking out the loan. But remember, there are scholarships and low-interest loans to help you pay for college. There aren’t these options to pay for your retirement.
Part of a healthy financial plan includes strong retirement savings. When you borrow against your 401(k), you put your retirement in jeopardy. Think carefully and do your research before making this decision. Building an emergency fund can keep you from being in the situation where you need to borrow against your 401(k).
Tips for Preparing for Retirement
- Before you dip into your retirement savings, consider how it will impact your retirement goals. SmartAsset’s retirement calculator allows you to input all your information and come up with a savings goal you can center your saving strategy around.
- Everyone’s financial situation is different, so there’s no one-size-fits-all answer to how much you should stash in your 401(k). SmartAsset’s 401(k) calculator can help you determine what your contributions will be worth once it’s time to start withdrawing.
- If you’re choosing between retirement savings and other financial priorities, it may be time to speak with a professional. The SmartAsset financial advisor matching tool can help you find an advisor to meet your needs.
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