Tapping Into 401(k) Early Gets Warning Flag

BOSTON (TheStreet) -- If you spend time at the beach this summer, you may notice the "current conditions" flags that warn swimmers about the water currents or surf. A red or black flag generally means it's too rough and one should avoid swimming; a yellow or orange flag typically signals light surf and advises swimmers to use caution; a green flag usually means calm waters.

With finances, we can use the same flags to help identify when it is a good idea to use a particular financial strategy or when the circumstances suggest it's best to avoid it.

Tapping into your 401(k) prematurely may be one of those "yellow/orange" flag circumstances. To avoid drowning in debt or another emergency situation, it may be tempting to access funds originally set aside for retirement. Proceed with caution, though. Before using your 401(k) as your life vest, review the conditions carefully to assess whether you should dive into your retirement savings funds or perhaps swim elsewhere.

First, you need to know the specifications of your particular plan to see what kinds of options you have. Some plans actually prohibit any type of distribution unless one terminates employment. Other plans are more flexible and allow participants to take loans and borrow against the plan or take advantage of "hardship distributions."

Depending upon your plan, it may make the most financial sense to take a loan rather than a hardship withdrawal because you generally would not have to pay income tax or another type of penalty. You must be aware of your specific plan's loan restrictionsm, however. Usually, among other stipulations, the loan must be repaid at a reasonable rate of interest, cannot exceed $50,000 and must be repaid within five years to avoid additional taxes or fees. And if there is a chance you may leave your place of employment in the near future, a loan may not be the best option. Often a firm will require you to repay loans from the plan immediately, sometimes within as little as 90 days of termination.

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