Is it ever OK to borrow from your 401(k)? After all, it’s a powerful retirement savings tool and should be carefully husbanded. Indeed, new data from Fidelity shows that the average account balance has climbed to $92,500. The primary advantage of saving in a 401(k) is the ability to enjoy tax-deferred growth on your investments. When you’re setting aside cash for the long term, a hands-off approach is usually best.
There are, however, some scenarios in which taking money out of your 401(k) can make sense. Before you pull the trigger, though, it’s important to understand the financial implications of tapping your retirement plan early. There are two basic avenues for taking some money out.
You Could Take a Hardship Withdrawal
There are two different paths you can follow for taking money out of a 401(k) before reaching retirement age. First, you can take a hardship withdrawal. The Internal Revenue Service (IRS) specifies that hardship withdrawals are only allowed when there’s an immediate and heavy financial need, and withdrawals are limited to the amount required to fill that need. These withdrawals are subject to ordinary income tax and a 10% early withdrawal penalty if you’re under age 59½.
The IRS also offers a safe harbor exception allowing someone to automatically meet the heavy need standard if they are in certain situations. For example, a safe harbor exception is allowed for people who need to take a hardship withdrawal to cover medical expenses for themselves, a spouse or dependents. If you find yourself in a life or death medical situation, say one requiring emergency surgery, taking a hardship withdrawal could help to cover the gap if your insurance coverage falls short.
A hardship withdrawal could also be useful if you experience an extended period of unemployment and don’t have an emergency fund to fall back on. The IRS waives the penalty if you’re unemployed and need to purchase health insurance, although you’d still owe taxes on what you withdraw. Other situations that are covered by the safe harbor exception include:
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary
- Payments necessary to prevent the eviction of the employee from his or her principal residence or foreclosure on the mortgage on that residence
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary
- Certain expenses to repair damage to the employee’s principal residence.
(For more, see How 401(k) Withdrawals Work When You’re Unemployed.)
Or You Could Take a 401(k) Loan
If you’re not in dire financial straits but still want to take cash from your plan, a 401(k) loan is the other option. Under IRS guidelines you can borrow 50% of your vested account balance or $50,000, whichever is less. A loan, however, has both pros and cons.
For example, a loan is just that – a loan, not a distribution. You’re essentially paying the money back to yourself, which means you’re putting it back into your retirement account, and that’s a positive. Loans are usually repaid with interest, which can make up somewhat for the earnings you’re losing by not leaving the money in your plan. The downside is that if you leave your job before the loan is repaid, it’s treated as a regular distribution. In that case the income tax and early withdrawal penalty would apply.
So when is it wise to use a loan? There are a few situations in which you might consider it.
- Consolidating Debt – You could use a 401(k) loan to consolidate high-interest debt if your credit doesn’t qualify you for a low rate on a personal loan or debt consolidation loan. Looking at how much you’re paying in interest on your credit cards or other debt versus the interest rate your 401(k) plan administrator charges can help you decide which is the better deal.
- Buying a Home – Your 401(k) could also be a source of cash when you’re planning to buy a home. You could use the money to cover closing costs or hold it in your down-payment savings account for a few months prior to buying, so the funds are seasoned. Generally, a 401(k) loan must be repaid within five years, but the IRS allows provisions for plan administrators to extend the repayment period longer for homebuyers.
- Making an Investment – Using a 401(k) loan to make an investment may sound like a gamble, but it could be appropriate if certain conditions exist. Let’s say, for example, that you want to purchase a home as an investment property. You plan to renovate the home and flip it for a profit but need capital to make the purchase. If you’re confident that the project will yield a big enough return, you could use money from your 401(k) to buy it or pay for renovations, then use the proceeds from the sale to pay back what you borrowed.
- When You Have a Comfortable Retirement Cushion – If you’ve been saving steadily over the years and choosing solid investments, you may be ahead of schedule when it comes to meeting your retirement goal. If that’s the case and your job is stable, taking a loan from your 401(k) may not be too detrimental to your retirement outlook. You could use the money for the purchase of a vacation home, for example, or, if you have a child in college, as a less expensive alternative to student loans. (For more, see Sometimes It Pays to Borrow From Your 401(k)
The Bottom Line
Ideally, when it comes to your 401(k) plan, you should have a steady stream of money going in rather than out. If you do, however, decide to take a loan from your plan, or a financial need makes a hardship withdrawal a necessity, be sure you understand the potential tax consequences of doing so. Also, consider how taking that money out may affect the growth of your nest egg over the long term. Taking out a large withdrawal or loan may mean you’ll have to play catch up to reach your retirement savings goal.