Taking out a loan against your 401(k) is usually considered a big no-no by financial advisors. After all, you miss out on the chance to earn returns on the money during the loan period, and if you suddenly lose or leave your job, you'll have to quickly repay the loan within 60 days. You also miss out on the tax benefits, since you have to repay the loan with after-tax dollars.
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But according to a new paper from the Michigan Retirement Research Center, people do use their 401(k)s to provide cash for purposes other than retirement, and that's not necessarily a bad thing. Using a loan to pay off high-interest credit card debt, for example, can end up saving the borrower money. And the researchers point out that if workers know that a 401(k) loan is an option in case of emergencies, they might be motivated to funnel more money into their retirement account.
In a tough economy with tight credit markets, more workers are taking advantage of this option, with some 11 percent of account owners taking out a loan in the last 12 months, compared with 9 percent a year earlier, according to Fidelity. Just over 2 in 10 account owners currently have an outstanding loan, and the average size of the loan is $8,650.
Still, 401(k) loans aren't a good idea for everyone, since they come with some pretty big risks. To decide whether a 401(k) loan is a good idea for you, consider these six questions:
Does your company offer a 401(k) loan, and if so, what are the rules?
Your company might not offer a 401(k) loan at all, and if it does, it probably comes with fees and restrictions. Interest rates on 401(k) loans are usually slightly higher than the prime rate, but again, companies have discretion and could charge a higher interest rate. (That interest gets paid back into the account holder's funds.)
Companies can impose their own limits, but federal law allows account holders to borrow as much as half of their account balance, up to a maximum of $50,000. That means if you've saved $100,000, you can borrow a maximum of $50,000, but if you've only saved $50,000, you can access only $25,000. To avoid any surprises, make sure you know your company's policy.
How stable is your job?
One of the biggest risks with 401(k) loans is that you'll leave your job, either by choice or through a layoff. In most cases, you must immediately repay the loan, usually within 60 days, or you'll face penalties, such as a 10 percent tax. "It's not uncommon for people to change jobs frequently, and it's important to know those tax consequences," warns Catherine Golladay, vice president of education and advice at Charles Schwab.
Do you have a long-term plan?
Even though it might make numerical sense to take out a 401(k) loan to pay off high-interest credit card debt, it's not necessarily a good idea, says Golladay. Unless you have a long-term plan, you might find yourself racking up the same kind of expensive debt again, even with the 401(k) loan. "You might see your credit card debt paid off, but then a year later, when an emergency comes up, you're back in the same cycle," she says.
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Have you asked for help?
Your company or 401(k) plan provider might offer free counseling; at the very least, someone should be able to walk you through the plan's rules and fees. Gerri Detweiler of Credit.com recommends talking with a credit counselor and possibly a bankruptcy attorney before using 401(k) funds to settle debt. She adds that while consumers should be careful, sometimes it can be a smart move to use a small amount of retirement money to settle high-interest rate debt for a fraction of the total balance. "This could put the debt behind them and help avoid either a lawsuit or a bankruptcy," she says.
Will you continue to contribute money into your retirement account, even while you are repaying the loan?
If you stop making contributions to your retirement account when you take out a 401(k) loan, you'll be creating an even bigger hole in your retirement savings. According to one study, a loan of $30,000 can cost borrowers as much as $600,000 in the long run if they also stop contributing to their accounts during the repayment period. (That calculation includes the cost of missing out on market gains.)
Are you in danger of bankruptcy?
During bankruptcy proceedings, retirement savings accounts are usually protected, but a loan against your 401(k) would not be. That means it would be safer to keep your money protected in your 401(k) if you are in danger of filing for bankruptcy.
The bottom line: The old advice that 401(k) loans are always a bad idea is too simplistic. Sometimes, taking a loan against your retirement account can provide a much-needed cash boost. But make sure you have a long-term plan and understand the risks involved so you don't ruin your retirement funds and make a costly mistake.