When money is tight, people look for any possible option to make end’s meet. If they don’t have access to a personal loan or if they aren’t able to procure a credit card, they consider alternate options based on the resources to which they have access. Some choose to refinance their homes, others make withdrawals from their kids’ college funds, and still more choose to borrow against their 401K. If you fall into the latter category, there are a few issues you should consider.
First, it is always better to borrow against your 401K than to make a withdrawal. When you withdraw money from your account, the funds are subject to high taxes and fees (penalties) that must be paid during the tax year in which you withdrew the money. Although the IRS considers this a “hardship withdrawal”, it can leave you with far less money than you started with.
If you decide to borrow against your 401K, however, you don’t have to pay taxes or penalties on the amount withdrawn (depending on which 401k plan you hold); you simply have to continue to pay interest on the loan until you are able to pay it back. You lose the money that your 401K would have accrued during that time period, but your bank book doesn’t take any further hits as long as you pay it back within the time allotted.
Unfortunately, some employers don’t allow employees to borrow against their 401K accounts. Before you make any financial decisions regarding loans, check with your employer’s HR department to determine where your options lie. Whether or not they permit borrowing against your 401K will depend on the financial institution they work with and corporate policies.
If you discover that your employer allows loans borrowed against your 401K, you should start looking into other options, such as refinancing your home. The goal here is to determine which option at your disposal will cost you less in the long run. You can ask a financial advisor to assist you with this process or you can do it on your own. If all of your options come out to the same long-term costs, experts suggest that you don’t borrow against your 401K, but go with another plan.
The danger of borrowing against your 401K is not related to the interest you incur because all interest paid on the loan goes back into your account. Instead, the risk lies in the potential of losing your job or switching jobs to another employer. When this happens, the clock automatically begins ticking down to sixty days, at which point you must repay the loan in full. If you don’t, the loan you took out against your 401K will be considered a withdrawal for tax purposes and you will have to pay all of the penalties associated with such a maneuver.
Another thing to take into consideration when it comes to borrowing against your 401K is how close you are to retirement. Young people in stable industries can usually borrow without worrying about losing significant gain, but if you are nearing retirement, you could be endangering your retirement savings considerably. The general rule of thumb is to avoid borrowing against a 401K after the age of forty, but many experts have conceded the age to 45 or 50 since many of the baby boomers are working well beyond retirement age.
In the end, you have to make financial decisions that will benefit you and your family, whether that benefit presents itself now or in the future. While saving for retirement should be a high priority, you also have to think about your immediate needs and weigh those against what might come to pass down the road.