In desperate financial situations, tapping into your retirement funds may seem like your best or only option to stay afloat. As could be said for any major financial decision, your best approach before pulling the trigger on making a withdrawal from your 401(k) is laying out the various advantages and risks that it presents.
When to avoid taking out a loan
Tapping into your 401(k) may sometimes be the most viable option during a financial hardship, but there are conditions and situations that make this decision largely prohibitive. Financial Advisor Roger Wohlner, author of the article “401(k) Loans Pros and Cons” on Investopedia, outlines six specific scenarios where taking out a 401(k) loan “can lead to a financial train wreck.”
If you are nearing retirement, behind in your retirement saving, feel that paying back into your 401(k) could create greater financial strife, not confident in your level of job security, plan on leaving your job in the near future or have other available options for procuring the money you need, avoid borrowing from or against your retirement plan.
With regards to the point of having other borrowing options at your disposal, Wohlner advises that borrowing or taking a loan out of your 401(k) “should not be done lightly and should be the last resort source of funds.”
The best time to take money out of retirement
Bearing in mind the idea that it is generally unadvisable to borrow from your retirement, there are some situations where you can borrow safely so long as you know how to do it. With respect to an IRA, the Internal Revenue Service (IRS) writes that, “If the owner of an IRA borrows from the IRA, the IRA is no longer an IRA, and the value of the entire IRA is included in the owner's income.”
However, Dr. Don Taylor, Ph.D., writing for Bankrate.com, says that there is a provision that permits those with traditional IRAs to withdraw under the condition that the amount is repaid in full within 60 days. This, as The Motley Fool’s Investment Planning Specialist Matthew Frankel notes, is called the rollover rule as it is “designed to allow people to move money between retirement accounts and financial institutions easily.”
Because of this, the money can be used for non-retirement purposes after it is withdrawn, but only so long as it is either returned to the IRA from which it was withdrawn or put into a new IRA account. To ensure that this provision is not abused, the IRS states that “you cannot, within a one-year period, make a tax-free rollover of any later distribution from that same IRA. You also cannot make a tax-free rollover of any amount distributed, within the same one-year period, from the IRA into which you made the tax-free rollover."
Of course, if you are withdrawing an amount from your retirement that could be paid within a 60-day period, your best option may be to seek a traditional bank loan, withdraw from non-retirement savings or seek out other, less risky avenues.
Other associated risks
Among the multitudes of risks associated with taking a loan or borrowing from your 401(k), Wohlner includes penalties and fees. In addition to borrowing and repayment costs, plan providers tend to charge fees for processing and servicing loans, which means you are out more money than you started with. Because that money is out of your retirement for any period of time, you are also suffering in terms of opportunity cost.
“While you do pay interest to yourself when repaying the loan through payroll deductions, the interest rate pales compared to what you could earn by being fully invested in your 401(k) account. The S&P 500 Index was up more than 200 percent from the market lows of 2009 through the end of 2014. Investors with a large chunk of their 401(k) tied up in loans missed out,” Wohlner writes.
Desperate times do sometimes call for desperate measures, but by and large, borrowing from your retirement funds should only be reserved for those grave occasions. Even then, it is best to first weigh your other options and make sure that you have no other choice before touching those savings.