When life gets financially tough, dipping into your 401(k) for emergency funds might sound like the easiest solution. If you’ve considered this or done so, you’re not alone: about 20 percent of people who have a 401(k) plan who are eligible to take loans against their retirement savings in fact do so, according to research from the Employee Benefit Research Institute.
While there are appropriate times to take money out, more often than not, taking out a 401(k) loan is considered a no-no. Read on to find out why you may want to hold off:
You won’t have that money - The main reason experts vouch for not taking a loan from your 401(k) is simple and obvious — but makes the most sense: you’ll have less money for retirement.
“Many people don't have enough saved for retirement in the first place, and when they take their 401(k) out of the equation and borrow the money — typically up to 50 percent of their balance — then that money is no longer working for their retirement needs," explains Bob Mecca, financial planner and president of Robert A. Mecca Associates in Illinois. If you absolutely need to take money out after considering all other options, that’s one thing, but to use your 401(k) funds to expense a vacation or pay your mortgage, the money will be gone if a time comes where you really need it.
You lose time - It’s been calculated that your 401(k) balance doubles about every eight years (at around an eight percent rate of growth). When you take money out of the account, you’re not only purging your hard-earned physical money, but you also refract the time it took to reach the amount you had. Over the course of the next years until you hit retirement, depending how much you withdrew, your balance isn’t likely to ever get to the top amount you would’ve had come retirement.
You’ll owe taxes - One of the biggest benefits of having a 401(k) is that it’s taken from your paycheck tax free. However, when you withdraw from your 401(k) before retirement, you’ll have to pay taxes on them.
“The money is no longer growing, compounded, and tax-deferred,” explains Mecca. While it’s true that contributions will be taxed when you do retire, if you had waited, it’s possible that you might have fallen in a lower bracket and paid a smaller amount in taxes.
While taking money out of your 401(k) to pay for something other than retirement is often frowned upon, there are occasions when it may be your best bet. Good reasons to take a loan from your retirement savings are:
When you think there’s no other choice - It’s smart not to take out a loan unless you’ve exhausted all other options, such as a home equity line of credit or borrowing from a family member or friend. And make sure it’s something you absolutely cannot negotiate.
"Even though what's facing you today can look pretty ugly, like when you can't pay your credit card bills, those can be negotiated," says Joel Larsen, principal of Navion Financial Advisors, CA. Even making partial payments may be more beneficial than taking a loan from your 401(k) — but if absolutely necessary, it’s good to know you can default to that extra cash cushion.
When your credit score dips - Whether due to bankruptcy or engaging in a short sale, taking money from your 401(k) may be a good option if you’re having issues getting credit at a rate you can afford.
“When they get ready to go into the market, instead of subjecting themselves to two (percent), three (percent) or four percentage point increases in rates or not getting credit at all, (a 401(k) loan) could be a resource," says Robert Gordon, senior financial adviser with Investor Solutions in Coconut Grove in Florida. Just be sure to calculate if that’s a good option for you, thus find out if interest you’re saving by taking a loan from a 401(k) rather than, say, a financial institution, outweighs the amount lost from your account.
When it’s worth it - Sometimes, for certain purchases, such as buying a home or business, borrowing from your 401(k) could be a good investment. It’s typical for those purchasing a home to be allotted an extended repayment period. Also, a 401(k) loan could be an option if you’re looking to go back to school, whether to advance your career or get a certification.
“You've really got to be careful about where you invest those dollars," Gordon advises. “So if someone says, 'I want to get a professional management certification,' understand what the value of that is in the marketplace before you make that investment.”