You’re working towards retirement, but you need a bit of a cash infusion right now. Maybe an unexpected debt showed up in the mail, or you find yourself without work for a short period. What do you do?
You could borrow from your 401(k). However, if you plan to retire early or on time, you'll need to ensure your funds can grow in your retirement account as long as possible.
Pulling money out of retirement savings can push your retirement back. What's more, you'll have to pay back the loan or incur tax penalties.
Before you dip into your 401(k) loan, look at all your alternatives and make sure it's the best choice.
You lost your job
Sometimes, you simply need the funds in your 401(k) now. You may be facing the loss of a job and need money to pay your bills.
Just be sure you're utilizing your funds as a loan rather than a withdrawal. Withdrawals come with a 10% tax penalty, which could be a costly loss.
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You’ve become disabled
In some situations, you may be able to tap into your 401(k) balance if you become disabled and need help covering your medical bills.
However, if you're unlikely to be able to go back to work, consider requesting a withdrawal waiver. This can provide you with access to your funds without the 10% penalty and no debt to repay.
You need a down payment for a home
One of the most logical times to borrow from a 401(k) is when you’re using the money as a down payment to purchase real estate.
You want to borrow as little as possible, and then use those funds to buy the home that fits your budget and long-term goals.
Typically, you’ll still pay more interest on a 401(k) loan than you would by borrowing the same amount from your mortgage lender. But if you really need the down payment, it may not be a bad move.
You have high-interest debt
Use your 401(k) funds to pay off your debt if the existing credit card debts and other debts have high interest rates.
For example, if you’re paying 29% on credit card balances and could qualify for a 401(k) for 10%, there’s a big savings potential there.
Of course, you will have to repay the 401(k) loan, so if you take this route, be sure you're not just extending your debt further.
You owe back taxes
You don’t want the IRS after you, and that’s why you should stay up to date on your taxes in all situations. If you're unable to pay the taxes you owe, you could use your 401(k) to help you cover those costs.
However, you may also be able to work out a low-cost payment plan with the IRS. Determine which is the most financially sensible for you.
Remember, you’re not only borrowing money from your 401(k), but you're also losing out on the potential growth of those funds over time.
You need to pay education expenses
It's possible to avoid the costs associated with a penalty if you're using the funds from your 401(k) to pay for qualified educational expenses.
You can use the funds to cover up to 12 months of tuition and fees for education. However, if you qualify for a low-cost loan and financial aid, that could be the better way to pay for these costs.
You need medical care
Essential medical expenses can be worth using your 401(k) funds for. We’re not talking about cosmetic procedures here, but rather life-improving or necessary medical procedures that you need to pay upfront, or when your insurance won't cover the costs.
You could lose your home to foreclosure
Another time when it may make sense to borrow from your 401(k) is if you're at risk of losing your home to foreclosure due to non-payment of your mortgage. You can often get a hardship withdrawal for this.
Before you make that decision, however, be sure you’ll be able to continue to pay your mortgage once you get caught up. If it’s just going to be a long-term financial struggle, it may be better to allow the home to be sold or foreclosed upon so you can start over.
You need long-term rehabilitation
After an accident or serious illness, you may need long-term care until you regain your health and strength.
In these situations, borrowing from your 401(k) to pay for these medical needs that your health insurance won’t cover or to help fund your day-to-day costs while you heal is often well worth it.
You can use your 401(k) balance through a loan or a hardship withdrawal, in this case, depending on what your financial picture looks like long term.
Covering funeral expenses
Taking a loan to cover the costs associated with the funeral and burial costs of a spouse or child may be a very worthy reason to borrow from your 401(k). For many people, an unexpected death is very costly to afford otherwise.
You could be evicted from your rental
For whatever reason, you can't make your rent payment… again. You’re behind, looking for ways to pay your rent, and the fees are adding up.
You could use a hardship withdrawal from your 401(k) to help you, but be sure you’ll be able to get back on track with your budget. Otherwise, it may be better to find a new rental home with lower costs.
Pay for necessary home repairs
Don’t borrow from your 401(k) to cover the cost of redecorating but do so when you need to fix a cracked foundation or a massive leak.
In cases of significant home improvement projects, using a 401(k) loan could make sense, but only if it is the last option available to you to cover those costs.
You need to get out of a payday loan
The payday loan cycle can be very difficult. You’re often borrowing money and paying extra fees every two weeks just to pay off the previous balance. You may wish to use a 401(k) loan to help you get out of that cycle.
Just remember that it will cost you interest, but it may allow you to stop having to borrow at such high costs through a payday loan.
You’re confident you can pay it back in the short term
Borrowing from a 401(k) for any other reason may be an option, but that doesn’t mean it’s financially sound.
If you can confidently pay the funds back, continue to invest in your retirement, and maintain your job, then you may be able to use these loans for other needs.
They come at the cost of reducing your retirement savings, and that’s hard to repay.
Whenever possible, use other financial tools to help you meet your obligations. That may include using a home equity loan, or you may be able to make a little extra money with a part-time job.
If you have no other option, borrowing from your 401(k) could help you extend your financial well-being. But there are limits to how much you can borrow, and you do have to pay it back to avoid tax penalties.
Just make sure that your budget and long-term goals are aligned to avoid borrowing in the future.
FinanceBuzz is not an investment advisor. This content is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.