There may come a point in life when there is an unexpected need for a substantial amount of money. Attorney’s fees, medical expenses, or a bill from the IRS are all examples of circumstances when you might start to consider your financial resources and how you are going to come up with a large sum of money.
Only 28% of adults in the U.S. have emergency savings* which is approximately six months of income for a single person. If you are someone with little or no emergency savings and there is an unanticipated big bill to pay, is borrowing from your 401(k) a good idea? It might be the right choice depending on your financial situation and if you do have access to 401(k) savings, but first some factors should be considered:
- Before taking a loan from a 401(k), consider if you have any other options. For example, consider applying for a Home Equity Line of Credit or, if you have a large medical bill, perhaps they offer a payment plan.
- If a loan from your 401(k) is the only option, understand there are consequences in certain scenarios. If you had to leave the company you work for or the company is sold where your 401(k) is held and the loan is outstanding, you will have to pay back the balance due. If this is not possible, the loan will be considered a distribution and you will have to deal with a 10% penalty (if you are under 59 ½) and you will pay taxes on the loan amount since it will be considered income. If borrowing from your 401(k) is your only option and you have no other way to access funds at such a low cost, then the 10% penalty might be worth it for a true emergency.
- There are bad reasons to borrow, for example, to pay rent, go on a dream vacation, or to perpetuate poor financial practices by paying off credit card debt with the loan. As a result of people borrowing for the wrong reasons, there are plenty of negative commentaries and articles supporting why it’s not a good idea to borrow from your 401(k.) In order to protect your financial future, consider if the loan you are taking is sensible.
- You might believe that borrowing money from your 401(k) can negatively impact your investment performance but that is not always the case. It is true you could potentially miss out on investment gains and affect your retirement savings progress. However, looking at the glass half full, the money you borrowed may have avoided exposure to investment losses if you took the loan and, subsequently, the markets took a turn for the worse. Also, when you take the loan, you will be paying yourself back plus interest so you are ultimately forced to contribute to more than amount you borrowed.
In the end, it may make the most sense to borrow from your 401(k) in light of the ease and flexibility a 401(k) loan provides and it typically costs less compared to taking a personal loan through a bank which can require credit checks and paperwork. If the loan is absolutely necessary, many experts say that one loan won’t cause a major problem and can be a resourceful way to deal with and unexpected financial setback or need for cash.
* Source: bankrate.com