If you’re thinking about borrowing against your 401(k), tread carefully. Not only would you be messing with your retirement savings, you’ll also be running the risk of incurring penalties. If not handled carefully, you could also have less money saved than you planned when you’re ready to retire.
Some 401(k) plans allow you to borrow against the money in your 401(k) retirement savings account (it depends if your employer offers this option).
We go into some of the weighty considerations later on, but one reason this type of loan may merit consideration is that unlike some other loans, there’s no credit check because you’re borrowing against yourself, and you usually don’t have to explain why you want the loan.
However, there’s a lot more to choosing a loan than whether or not there’s a credit check; borrowing against your retirement account could include some significant downsides.
First, if you’re borrowing against your 401(k), you’re not just tapping into any pool of money– you’re taking money out of an account you created for your retirement, which means you’re potentially messing with your long-term savings.
Second, is repayment:
You need to repay your loan in five years or it counts as a 401(k) distribution.
If you’re not at least 59 ½ years old and haven’t repaid your loan in time, you could get hit with a 10% penalty for withdrawing your money early.
If you leave your job, you’ll need to repay your loan sooner than you expect: Depending on your plan, you may need to come up with the balance within 90 days or by the time you file your income taxes. Check with your financial advisor and/or 401(k) administrator to see when you may need to pay up.
Unlike your contributions, which were made with pre-tax dollars, when you’re in 401(k) payback mode you can only make those payments with after-tax income.
This loan can put retirement plans on the back burner: you’re earning less interest because your balance is smaller.
There are alternatives to a 401(k) loan that could help you keep your retirement savings on track. Here are a few:
Yes, you are taking on more debt, but you won’t have to worry about potentially having an early withdrawal penalty like you would if you were to take out a 401(k) loan and couldn’t pay it back on time.
Borrowing against the equity in your home using a HELOC could provide a relatively low-interest option, compared to credit cards, provided that you have built up enough equity in your home to qualify for a HELOC.
You set aside money for emergencies… for emergencies, so it may be worthwhile considering if your emergency fund should be used instead of pulling money out of your 401(k).