Taking money out of your retirement account early might be tempting, but it's almost always a bad idea. Jeb Graham, a retirement plan consultant at CapTrust Financial Advisors, an investment consultancy, says that more people are making this mistake as credit markets tighten. "When economic times get more difficult, then people will be more likely to take loans out of 401(k) plans," he says.
While borrowing from a 401(k) is relatively easy from a logistical perspective (it typically involves filling out paperwork without the pre-approval process of a bank loan, for example), it can have a lasting negative impact on retirement savings.
Those risks include:
• Job loss. If you lose your job, the plan administrator will still require you to pay the loan back. If you can't, then it will be subject to a 10 percent premature withdrawal penalty.
• Lack of compounding. As long as the money sits outside your retirement account, it will not be accumulating gains or interest.
• Taxes. Since your 401(k) is pre-tax money but you will be paying back the loan with after-tax dollars, you'll lose those tax benefits.
• No protection. During bankruptcy proceedings, retirement savings accounts are usually protected, but a loan against your 401(k) would not be.
Graham acknowledges some exceptions to the rule, however. If taking out a 401(k) loan means saving your home from foreclosure, paying off a divorce settlement, or some other life-changing event, then it might be worth considering. But otherwise, save it for its intended purpose. "Chances are the money will never make its way back to savings and you'll be hurting yourself in the long run," Graham says.