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When to Borrow from Your 401(k)

Tempted to dip into your retirement? Know the risks.

The decision to borrow from a 401(k) plan can be complicated. Although many financial advisers say never do it unless in a true emergency, others point out that it can be a useful tool if used wisely.

“The answers are unique to each person,” says Michael Doshier, vice president of marketing for Fidelity Investments in Boston, which manages $760 billion in 401(k) assets. He cites a person’s age, the amount of assets in the 401(k), their debt load and credit rating as all factors in the decision.

Although he says borrowing from your 401(k) should be a last resort, he acknowledges, “If there wasn’t a safety valve allowing people to take money out of their 401 (k) plans, many people wouldn’t invest in them at all.” 

“It’s OK to borrow from a 401(k) plan if you understand the risks involved," says Christine Fahlund, a senior financial planner at T. Rowe Price in Baltimore, another major 401(k) plan manager. "It can be a convenient way of getting out of a jam.”

But those risks are real. For example, if a person leaves the company before they have repaid the loan, the money counts as ordinary income and they have to pay taxes on the withdrawal. “If someone works for a company where they think there might be layoffs and they would lose their job, they shouldn’t do it,” she says.

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The only situation where Fahlund says it’s a sound decision to borrow from a 401(k) plan is if you’re sure you can pay it back quickly.  If a high level executive expects a hefty bonus in December, he or she can take a 401(k) loan in November and repay it soon after.

But Dawn Bennett, a financial adviser and president of Bennett Group Financial Services LLC, argues strongly against borrowing from a 401(k) plan. “To borrow in this market environment and think you’ll be able to replace it is unlikely,” she says. “You can’t rebuild what you take out because of the problems with the stock market,” which she expects to continue for quite some time.

A hardship withdrawal can be a valuable time to draw from a 401(k), says Brett Ellen, CEO of American Financial Network in Calabasas, Calif. It requires a person to be out of the 401(k) plan for six months, to buy a house, for example. The deduction of interest payments for the loan offsets the interest lost on money taken from the 401(k) plan. If the person takes the withdrawal in January, they can reenter the plan in July, making contributions which helps replace the money taken out for the loan.

In the current market conditions, Ellen also thinks it makes sense to take money out of a 401(k) plan to pay the taxes required to turn a regular IRA into a Roth IRA. “As long as you’re in a low tax bracket it makes sense.” He explains that when the money is taken out of the Roth IRA it will be tax free.

However, “first and foremost, 401(k) loans should not be viewed as an ATM machine,” says Bradley H. Boford, a managing partner at Financial Principles LLC in Fairfield, N.J. “I typically advise clients to use 401(k) loans as a last resort option. If someone needs to access money and has exhausted other options (current savings, emergency reserves, investment portfolios, cash values from life insurance policies, etc) then it can be a handy tool,” he adds.

Boford explains that borrowing from a 401(k) plan can be better than other options such as using credit cards or cash advances at much higher interest rates. “The last factor to consider is that you are essentially taking a loan against yourself, which always is a better option than paying interest to an outside disinterested financial institution,” he concludes.