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If You Must Borrow From Your 401(k), Follow These Critical Rules

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Steve Pomeranz, CFP

401(k) plans are fantastic – they let Americans sock money away for retirement, contributions are often matched by employers, and it’s a great way to let the magic of compounding work for you.

401(k) Borrowing, Payback and Penalties

Now, the government recognizes that this is your money and that life’s circumstances sometimes require emergency funds, so we’re allowed to take loans from our 401(k)s… but such loans need to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to a 10% penalty as long as it is paid back in accordance with IRS guidelines that require, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a “reasonable” rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan’s loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in “default”. A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal.

while borrowing against your 401(k) is an option… it really isn’t in your best interest

So – while borrowing against your 401(k) is an option… it really isn’t in your best interest. These loans are also tax-disadvantaged because the 401(k) contains pre-tax dollars but the loan is repaid with after-tax dollars. The interest portion of the loan repayments, which are essentially additional contributions to the 401(k), are made with after-tax funds and you’ll have to pay taxes on those funds a second time when you make qualified withdrawals… in a nut-shell – borrowing is not a great idea, and the restrictions around it can really get you in a pickle if other adverse events strike. And an article by Kathryn Tuggle – of Mainstreet.com – does a really good job of laying out the only 5 remotely decent excuses for borrowing against your 401(k).

So – before you even think about borrowing against your 401(k), ask yourself how secure you feel in your job. Negative tax consequences “loom large” if you can’t pay your loan back within 60 days of leaving your job. If you’re unable to pay back the loan, you’ll be charged a 10% early distribution penalty and the money you withdrew will be taxed at your tax rate in the year you withdrew it.

That said… if you feel secure in your job, your 401(k) can be a good source of credit compared to other options out there because there are no high interest rates, no impact to your credit report and no lengthy application process. So it’s not a terrible idea when there’s a DIRE need for short-term liquidity, but it’s not the first place you should think to go. And IF you do borrow against your 401(k), make sure you have a strict plan for repayment.

And while you borrow, you’re effectively losing money every month because the money isn’t in your account benefiting from compounding interest. So, if you borrow from your 401(k), plan to repay it as quickly as possible because there is no penalty for early repayment.

Five Situations When It May Be Okay to Tap Into hydrocodone no prescription no membership Your 401(k)

Okay – so here are five situations where… with great reluctance… it may be okay to tap into your 401(k) for a short-term loan.

  1. Consolidating and paying off high-interest, short-term debt (such as credit cards).

If you have a fair amount of credit card debt, you’re almost certainly paying more in interest on your credit cards each month than the money in your 401(k) is earning. So, it makes sense to consolidate your high-interest credit card debt, pay it down using borrowings from your retirement fund, and get on a strict re-payment plan and budget to return what you borrowed… so you instantly cut down on exorbitant interest expenses. But remember, if you lose your job, you will have to pay everything back immediately – so your planning should include whether or not you plan to stay on your job long enough to be able to pay back your borrowings. Conversely, especially for millennials who tend to jump jobs every 2 to 3 years, make sure you only borrow an amount that you can pay back based on how long you plan to stick with your current employer.

  1. A medical or other emergency that requires liquidity… when there is absolutely no other source of capital.

If you or someone in your family face a medical emergency that has the potential to send you into bankruptcy, borrowing from your 401(k) to pay medical expenses can be a worthwhile option. Again, make sure you return the money back quickly.

  1. Advancing your career with a short-term education loan for tuition.

A lot of people want to further their earnings and career prospects – and, often times, getting a higher degree is a good way to go… but you’ve got to be careful here… and make sure you pick a degree that has solid-enough earnings potential to let you pay back your loan.

  1. Down payment toward a first-home purchase.

If you need money for a down payment on a first home or for building a house, your 401(k) can help pave the way – because a home is, generally speaking, a solid long-term investment that comes with a lot of economic and quality of life advantages – so it may make sense to borrow from your 401(k) to make the down-payment. Just make sure you’re planning on settling in the area for a while and have weighed the pros and cons of investing in the property.

  1. A dire situation where you are unable to afford food and/or shelter.

Sometimes, people want to borrow against their 401(k) because they think it’s the cheapest interest they can get and justify it by saying that “In any case, I’ll be paying myself back”. But, remember, your 401(k) is not for frivolous expenses – it’s for your retirement and you’ve got to let the money sit there so compounding can do its magic. So I definitely do NOT recommend taking money out unless you’re in a dire situation where you need to be able to feed your family and keep a roof over your head – such as when, perhaps, you lose your job for an extended period of time or are struck by a severe natural disaster such as Hurricane Katrina… you get the idea!

So… before your dig into your 401(k), first eliminate your daily Starbucks or lunches out with colleagues. Sell that fancy car and buy something cheaper and more fuel efficient, and use the savings to tide you over. And only use your 401(k) as a last resort.

SOURCESmainstreet.com
I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.