Even with the best financial planning, unexpected emergencies still arise in our lives. If you find yourself in need of cash quickly, you may be hesitant to dip into your retirement savings.
There’s a good reason to be hesitant. If you touch the money you have saved for retirement; it can have unwanted consequences. But many people may not realize they can also borrow money from their 401(k). When done for the right reasons, taking out a 401(k) loan can help you get out of a tough financial situation.
401(k) Loan Basics
Before you consider taking out a loan from your retirement savings, it is important to understand exactly what this entails. 401(k) loans do not follow the traditional definition of a loan, as there is no lender and no evaluation of your credit history. While your 401(k) is not a liquid asset, it is still 100% your money. At its core, a 401(k) loan is the ability to access some of your retirement savings on a tax-free basis.
Usually, you can borrow up to $50,000 or 50% of your assets, whichever is less. As with all loan types, you must work to repay the money borrowed. However, the rules designated by your 401(k) plan have unique features, benefits, and consequences other loan plans do not.
When a 401(k) Loan Makes Sense
Just because you can borrow from your retirement fund does not mean that you should do so without significant considerations. Weigh the possible risks of borrowing from your 401(k) versus taking out a commercial loan and consider how quickly you can pay the loan back.
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After keeping these considerations in mind, how do you know if a 401(k) loan makes sense? There is an appropriate time and place for borrowing money from your retirement fund. When you need a lump sum of cash for a serious short-term need, your retirement should be one of the first places you turn.
For example, the coronavirus outbreak interrupted income flow for millions of people. If you lost your job and need liquid assets as soon as possible, borrowing from your 401(k) makes sense. Of course, you cannot forget about the repayment. In most cases, the terms of the loan will require you to repay within five years, but, as with any loan, it’s beneficial to pay it back sooner.
Why Borrow From a 401(k)?
If you are hesitant about tapping into your retirement fund, there are a few benefits you should be aware of. Because there are no required credit checks, a 401(k) is convenient and quick, so you’ll get money in your pocket quickly. Additionally, you are afforded some flexibility when paying back your loan. In many cases, your 401(k) plan will allow you to make payments via payroll deductions, and you can pay it back as quickly as you like with no prepayment penalties.
Compared to a consumer loan, you will not be paying back high levels of interest. Though you will need to pay back a 401(k) loan with interest, this interest is paid back into your own account. In some cases, because you’re paying back a little more than you borrowed, you can increase your retirement savings.
What are the Consequences of Borrowing from Your 401(k)?
While borrowing money from your 401(k) is a convenient and flexible way to access your money during an emergency, doing so doesn’t come without consequences. There are several things to keep in mind before taking out a 401(k) loan. As mentioned above, you will have to repay more than you initially contributed because of interest. You also must remember that, while you earn a return on retirement investments, you won’t be making any ROI on the money you borrowed.
If you leave your employer before paying back the 401(k) loan, it may be treated as a taxable disbursement, which means you’ll have to pay taxes on the money you borrowed unless you pay it back in a given timeframe. If your financial situation worsens while you’re trying to pay back your 401(k) loan, you could end up in hot water. If you are unable to repay your loan within the time allotted, it will be treated as a withdrawal.
Your 401(k) is a financial cushion, and when you borrow money, you lose that cushion. Be sure to carefully weigh all your options before you take out a loan.
Before you make any serious financial decisions, like borrowing money from your retirement account, it’s a smart idea to consult with a financial planner. These experts can help you decide if this is the best option for your current situation, or if it is a better idea to take out a loan from another financial institution.
While it’s hard to deny the ease and convenience of a 401(k) loan, these loans should only be considered if you are sure you can pay back the funds in the given timeframe. Remember, your 401(k) is your money, and it can be a smart idea to use the money you already have instead of turning to a high-interest loan from a creditor.
Brian Menickella is a co-founder and managing partner of The Beacon Group of Companies, a broad-based financial services firm based in King of Prussia, PA
Securities and Advisory services offered through LPL Financial LPLA , a registered investment advisor. Member FINRA/SIPC.
This information is not intended as authoritative guidance or tax or legal advice.