For most of us, our 401(k) is the primary way that we build a nest egg for our retirement. However, most 401(k) plans allow you to borrow up to $50,000, provided that your vested balance is this large. Is there ever a time that you should do this, or should you regard your 401(k) as completely sacrosanct?
The short answer is that there are very few conditions under which you should take a 401(k) loan. Sometimes, when you have run out of all other financial resources, then you are left with no alternative – but in general you should always look for other sources of money before you tap into your retirement savings. There are some exceptions to this, but they are few and far between. For example, if you are a small business owner, occasionally it can make sense to tap into your 401(k) for expansion, but only if you can’t find any other funding sources. However, even in this case, you need to make sure that you really will see a return – don’t use your 401(k) to try to bail out a failing business.
One of the main reasons you shouldn’t take a 401(k) loan is the opportunity cost. If your 401(k) is well managed, you will be generating significant tax-free returns every year – much more than you would get on another investment such as a CD. For instance, comparing term & jumbo CDs at CIT, you are likely to generate 5 to 6 times the return with a 401(k), even though the CD rates at CIT are some of the best available.
It is even a mistake to use your 401(k) to pay down expensive debt such as credit cards. Although you are likely to get a much better rate of interest on a 401(k) loan than on a consolidation loan, the problem is that many people who do this just go and run up their credit card debts again. This can lead to a cycle of repeat 401(k) borrowing. For instance, a recent survey by Fidelity Investments showed that 50% of people who borrow from their 401(k) do so more than once, and those who do borrow tend to save less. In other words, borrowing from a 401(k) is often a symptom of a deeper problem – including the type of undisciplined financial behaviour that leads to high credit card debt levels.
Another serious consideration with a 401(k) loan is what happens if you lose your job. If this happens, you will be required to pay back the full amount of the loan within 60 days. Otherwise, you will have to pay some taxes on the balance of the loan – as well as a 10% penalty if you are less than 59 1/2 years of age. Since you presumably took out the loan in the first place because you were under severe financial stress, it is unlikely that you will be able to do this – which can lead to bankruptcy.