Okay, so you're in a financial bind during a global pandemic, and could use some quick cash as a bail-out. Should you borrow from your 401k? After all, you may be many years from retirement, and borrowing from your 401k is no problem - you can easily pay the money back.
Maybe – and maybe not.
Most 401k plans let you borrow up to half the balance (or $50,000 - whichever is less), with a five-year period to repay the loan - or longer, if you're using it to buy your first home. Interest rates are usually only a few points above the prime rate, and can vary widely, so you may even catch a break on a good rate. Plus, there's no credit check required, and with some plans, your money is only a phone call away.
In theory, it's a great idea - borrow from yourself, and pay it back with interest. But as with most financial issues, it's not as simple as it sounds. Can you afford to forego the tax-interest your retirement funds otherwise could - and should - be earning all the time?
Personally, I am against taking out 401k loans. The money you’ve accumulated, and then taken out will be difficult to replace, unless you pay the loan back right away.
In addition, you are curbing the power of compounded interest, which helps your money grow over time. Taking cash away from compound interest is like taking fuel away from an engine – it curbs performance.
Still, I understand that people might have a financial emergency during the COVID crisis, where the money is needed until the health crisis, and resulting recession, dissipate.
So let’s take a look at the topic of 401k loans (and other loan possibilities) and see where they may be of value. Here’s a checklist:
Evaluate all your options. Do you have a money market account? Or a savings account that’s not earning much interest? Borrowing money from either of those poses less risk for your long-term financial health than from a 401k. You might also check into an unsecured debt consolidation loan (in the form of a personal loan). These tend to carry higher interest rates (although rates are lower in 2020) than a mortgage refinance or home equity loan, and the interest won’t be tax-deductible. But it’s still a better deal than most credit cards.
Tap in – but proceed with caution. If none of the above options apply, and you’re in a real financial emergency, borrowing from the 401k definitely beats making a hardship withdrawal. The good news is the money can be repaid at relatively low-interest rates. Just be sure you can repay yourself within the required time limits - and still make contributions to your 401k plan, so your retirement nest egg doesn’t take a major hit.
Pay yourself back. Otherwise, your loan will be considered a premature distribution (assuming you’re under 59 ½ years old), and you’ll pay a 10% penalty, along with state and federal income taxes.
Read the fine print. If you change jobs, there’s a good chance you’ll have to pay the loan back immediately, in full, or face steep penalties and tax charges.
Don’t make a habit of it. As I said above, borrowing from your 401k may be a viable option in a pinch, but don’t let yourself fall into a pattern of dipping into your 401k instead of saving for things you need along the way. That’s a recipe for long-term financial troubles.
Also remember that you’ll miss out on any matching funds your employer may offer.
You Want Fries With That?
Consider a 401k loan as a last resort - as tempting as it may be to cash out during a tough period of time, as we're all experiencing in 2020.
In most cases you'll find there are better ways to borrow than risking your retirement funds - and avoiding raiding your financial future in the process.
In fact, it may mean the reality of spending your golden years working under the Golden Arches.