Taking out a 401(k) loan is like cutting off your own limb. Most advisers would call it an act of fiscal insanity, unless you're genuinely trapped with no other financial lifeline available.
"Many people don't have enough saved for retirement in the first place, and when they take their 401(k) out of the equation and borrow the money -- typically up to 50 percent of their balance -- then that money is no longer working for their retirement needs," says financial planner Bob Mecca, president of Robert A. Mecca Associates in Prospect, Ill. "And the money is no longer growing, compounded and tax-deferred."
Of course, it's best to avoid such a moment of desperation in the first place. Having an adequate emergency fund in reserve is a good way to steer clear. But let's say you're out of cash and you seem to be out of options for acquiring what you need. In this short list of scenarios, a retirement account loan might make sense.
Joel Larsen, principal of Navion Financial Advisors in Davis, Calif., insists that about the only situation desperate enough to justify a retirement account loan is one where "you have no money, you can't keep the lights turned on and you can't buy groceries." For everything else, you can negotiate.
"Even though what's facing you today can look pretty ugly, like when you can't pay your credit card bills, those can be negotiated," Larsen says.
Feeling pressure because of harassing phone calls from creditors? Send them a certified letter requesting they stop calling. Too many medical bills? Try to work out an arrangement to pay them over time before you tap into your retirement account. Even if your creditors refuse to negotiate, if you continue to make at least a partial payment each month, you won't be in default.
Robert Gordon, senior financial adviser with Investor Solutions in Coconut Grove, Fla., says a 401(k) loan could be a useful option for people who have problems getting credit at affordable rates -- for example, someone whose credit score has plummeted because of bankruptcy or a short sale.
"When they get ready to go into the market, instead of subjecting themselves to two (percent), three (percent) or four percentage point increases in rates or not getting credit at all, (a 401(k) loan) could be a resource," Gordon says.
Just remember that the interest you save by choosing a 401(k) loan over a bank loan still may not be enough to make up for your loss of earnings from taking the money out of your retirement account.
Bankrate's 401(k) loan calculator shows you how much your retirement nest egg stands to lose if you borrow from your 401(k).
If you're thinking about borrowing from your retirement account, make sure that you're happy with your employer, the boss is happy with you and there are no layoffs imminent, Gordon warns. If you leave your job, you'll generally be required to repay the loan balance immediately -- usually within 60 days. Plus, the money you took out now gets tagged as an early withdrawal, so you'll incur the 10 percent penalty and owe income taxes on the amount.
Also take into account your projected income over the course of the normal five-year loan repayment period. Payments on 401(k) loans usually are taken directly out of your paycheck -- on an after-tax basis -- so you'll want to be sure you can live without that money from your take-home pay.
Mecca says that when clients ask him about the advisability of a 401(k) loan to raise capital, he won't even go there unless they are confident of their job security.
"If there is hesitation on their part, then I try and look elsewhere," he says.
Under certain circumstances, borrowing from a 401(k) to purchase a home, finance a business or advance your education might be worth considering. The repayment period is often extended for homebuyers.
For example, Gordon had clients who had just moved to a new city and wanted to buy a house. They already had rolled over the 401(k) from a previous job into an IRA. You generally can't borrow from an IRA, so to get money for the down payment, they rolled money from the IRA into a new 401(k) and borrowed it back.
He cites another case in which an entrepreneur rolled money from an IRA into a solo 401(k) in order to take out money to invest in his business.
A 401(k) loan might also be useful for acquiring educational credentials needed to keep your job or advance your career, Gordon says. Just be sure that the piece of paper you are risking your retirement for is worth it.
"You've really got to be careful about where you invest those dollars," Gordon says."So if someone says, 'I want to get a professional management certification,' understand what the value of that is in the marketplace before you make that investment."
If you're on the fence about borrowing from your 401(k), don't climb over it! Bankrate offers a plethora of retirement calculators to help you with your retirement planning. In addition, be sure to check out these stories:
- Use Roth IRA as your backup
- 5 stages of financial planning
- Pitfalls of automated 401(k) plans
- Savings milestones for retirement
Copyright 2010, Bankrate Inc.