Borrow Against 401k plans is a bad idea

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A Good Way to Scuttle your Finances: Borrow from your 401(k)

A 401(k) plan is one of the best ways for employees to save for their retirement years. The key is for employees to invest as much money as they can in these plans, and then leave that money alone until retirement.

That last part is crucial: Withdrawing any money from your 401(k) plan before retirement is a serious financial mistake. Early withdrawal often comes with significant tax and federal penalties. And even if it doesn’t, it rarely makes sense for employees to gut their retirement savings. Money in a 401(k) compounds tax-free. But employees won’t see the true benefits of this if they withdraw a significant amount of dollars from their accounts before retirement.

Financial experts agree that employees should only withdraw money from their 401(k) accounts in dire financial emergencies. Such a drastic move might make sense for employees who have to make a down payment for a new home but have no other source of funds. It might be an option, too, for employees who have to pay for their children’s college tuition but, again, have no other source of funds.

But even in these emergencies, it’s best to exhaust all other possible sources of funding first.

Taking a Loan from your 401(k) Plan

Those employees who insist on withdrawing funds from their 401(k) plans have two options: They can take out a loan against their plans or they can ask for a hardship withdrawal.

The first option is by far the easiest, especially if the employee still works at the company that holds the 401(k) plan. That’s because the vast majority of plans do allow employees to take out loans. Such a process rarely requires much paperwork; in most cases, employees simply request a loan and receive a check. Workers can usually borrow as much as half, up to $50,000, of their vested account balance.

Employees most often have five years to pay back their loans. If they pay the loan back during this period, employees do not suffer any penalties. However, when paying back the loan, employees to have to pay both their principal and interest on it.

There is an additional catch. Employees who leave their jobs or lose them have to immediately pay back any loans they made against their 401(k) plans. If these employees can’t pay back their loans, they are treated as early withdrawals. This is bad: Employees will have to pay a federal penalty and taxes on the money.

Financial experts recommend that employees only resort to a 401(k) loan when they are in desperate need of funds and they have no other way to get them. Employees should not, in other words, borrow from their 401(k) plans to pay for a cruise or a home addition.

The Biggest Mistake: A Hardship Withdrawal

The second way for employees to withdraw funds from their 401(k) plans is to request a hardship withdrawal. This, though, should definitely only be used as a last resort.

This is because employees who receive a hardship withdrawal have to pay income taxes on the money they withdraw, and these taxes can be as high as 35 percent. In addition, employees have to pay a 10 percent federal penalty on the money they withdraw.

And the penalties don’t end there. Employees who take out hardship withdrawals are not allowed to contribute any additional funds to their 401(k) plans for six months.

Companies allow their employees to take out hardship withdrawals to pay for medical expenses, funeral expenses for family members, a housing down payment or college tuition. Employees can also make a hardship withdrawal to prevent eviction or losing their home to foreclosure.

Again, though, a hardship withdrawal should be an absolute last resort.

In fact, employees should consider any withdrawal from their 401(k) plans as a final option. Employees will need those retirement funds one day. It’d be a shame if they weren’t there.