Is Borrowing from Your 401(k) a Smart Decision?

A 401(k) is a retirement fund set up through one's employer. If your employer allows it, the time may come when you consider borrowing from it. However, is that a wise decision? Let's go over some vital questions that you should ask yourself in order to determine the answer.

Do You Qualify for a Hardship Distribution?

Under some, often extremely strict, circumstances, you may be able to withdraw money that won't be considered a loan and which you aren't required to pay back. Every company has a different set of standards and criteria that you must meet to qualify, however, it's worth looking into. Some possible qualifying circumstances may include:

  • Select medical expenses
  • Home purchase expenses
  • Family death expenses
  • Education
  • Preventing loss of housing

Remember, this is your retirement money, so you absolutely should still try to repay the money if possible. However, doing it this way means not having interest from a loan on top of paying it back.

Can You Afford the Deductions from Your Paycheck?

The money will be deducted from your paycheck automatically to repay the loan, which typically must be repaid in no more than 5 years. If you lose your job, you'll have to repay it by the due date of your next tax return. If the loan isn't repaid on time in any of those circumstances, you'll be subject to paying taxes on the money and incur a 10% penalty if you're under 59 and a half.

How Much Will It Cost You in Paid & Lost Interest?

Despite it technically being your money, you do pay interest on the loan. Currently, the interest is typically around 3.25%. Also, consider the compound interest you're losing every period that money isn't in the account. You may not be allowed to contribute until it's repaid either, costing you even more on your own contributions, your employer match, and the interest you'd have earned on that money.

Will You Have Enough for Retirement?

It may seem too far off in the future to worry about given more pressing concerns, however, many people are woefully unprepared for retirement costs. People are living longer than ever and now need to work far beyond the traditional retirement age due to a lack of savings. Retirement costs an average of almost three-quarters of a million dollars. Consider it wisely.

Do You Have Any Other Options?

Consider other loan types that may have lower interest and fewer consequences. These include:

  • Personal loan
  • Home equity loan
  • Home equity line of credit

If debt is the reason that you're considering the loan, first explore debt consolidation loans and debt counseling options. Medical debt can often be negotiated down and put on a payment plan. There are also charities set up to help with medical expenses.

Bottom Line

Borrowing from your 401(k) has a lot of drawbacks, so make sure it's your absolute last option. Also, many people who borrow from their 401(k) once, go on to borrow from it again, causing more damage and losing a lot of money. If you do need to borrow as a last resort, don't get in the mindset that you can just keep doing it. Being complacent about it may cause you to view it as a piggy bank, which it absolutely isn't. Think about your retirement needs carefully before deciding.