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Should You Borrow From Your 401k?

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Financially, times are tough and many Americans are looking under every couch cushion for extra change to make ends meet. Add in a  job loss or a sudden loss of income, and many Americans find themselves in an even tougher financial bind and in urgent need of money to get by until they can get back on their financial feet again.

If this sounds like your situation, you may be asking yourself: Should I borrow from my 401k?  At first glance, the easy answer is “why not”? After all, you may be many years from retirement, and figure you can easily pay the money back.

However, the real answer to this question is much more complex.

Yes, most 401k plans let you borrow up to half the balance (or $50,000—whichever is less), with a five-year period to repay the loan —or longer, if you’re using the loan to buy your first home.  Interest rates are usually only a few points above the prime rate.  There’s no credit check required and with some plans your money is only a phone call away.

In theory, it’s a great idea—borrow from yourself and pay it back with interest. But like most financial issues, it’s not as simple as it sounds. Ask yourself: Can you afford to forgo the tax-interest your retirement funds otherwise could—and should— be earning all the time?

Let’s break that question down further.

First, with any loan, be sure to do your homework, and be savvy about whatever form of loan you ultimately choose.

Next, look for alternative solutions. For example, if you’re a homeowner you may want to look into a mortgage refinance– mortgage rates are at historic lows, below 4% for those with good credit. Or, if you have a decent amount of equity in your home (not a certainty in the current economic environment), a home equity line of credit may be an option. The good news? With your home mortgage, you can use leverage you already have to pay off your debt – and the interest is tax deductible.

If that doesn’t work for you, start doing some detective work.Do you have a money market account? Or a savings account that’s not earning much interest? Borrowing money from either of these pose less risk for your long-term financial health.

You might also check into an unsecured debt consolidation loan. Keep in mind, though, these loans tend to carry higher interest rates than a mortgage refinance or home equity loan, and the interest won’t be tax deductible. Still, it’s still a better deal than most credit cards, and you won’t have to put a dent in your retirement fund.

If you have no other viable alternative, go ahead and tap into your 401k, but proceed with caution.If none of the above options apply, and you’re in a real financial emergency, borrowing from the 401k can help.  The good news is the money can be repaid at relatively low interest rates. Just be sure you can repay yourself within the required time limits —and continue to make contributions to your 401k plan, so your retirement nest egg doesn’t take a major hit.

Some other tips include:

  • Pay yourself back. If you don’t, your loan will be considered a premature distribution (assuming you’re under 59 ½ years old), and you’ll pay a 10% penalty, along with state and federal income taxes.
  • Read the fine print. If you change jobs, there’s a good chance you’ll have to pay the loan back immediately, in full, or face steep penalties and tax charges.
  • Don’t make a habit of it. Borrowing from your 401k may be a viable option in a pinch, but don’t let yourself fall into a pattern of dipping into your 401k instead of saving for things you need along the way. That’s a recipe for long-term troubles.
  • Employer Matching. Remember that you’ll miss out on any matching funds your employer may offer.

Consider a 401k loan as a last resort, and only after exhausting all other options, first. If you have no other options, make sure you pay the loan back as quickly as possible to keep your retirement on track.

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