Reasons to Borrow from Your 401(k)

While it’s generally a bad idea to dip into your retirement savings early, there are certain situations when borrowing from your 401(k) ahead of retirement makes sense — especially if you don’t anticipate any changes to your job situation, you’re still on track for retirement overall, and you have an urgent need for a one-time, lump-sum payment.

Hilltop CEO Erik Brenner recently spoke with WSBT-TV HomeTown Living co-host Jackie Jerlecki on why why 401(k) loans don’t always spell trouble.

Some highlights from the segment:

When does a 401(k) Loan makes sense?

Let’s face it, in the real world people sometimes need money. And borrowing from your 401(k) can be financially smarter than taking out a high-interest payday loan — or even a more affordable personal loan.

When you must find cash for a serious, short-term need  — for example, your water heater goes out — a loan from your 401(k) plan probably is one of the first places you should look.

Though, it’s essential to define “short term.” My definition of “short-term” is a year or less. It’s also essential to define a “serious need.” For example, repairs  — if left undone — would make a property uninhabitable or lead to illness or injury or would leave you unable to get to work.

But what about penalties? Aren’t you charged a significant penalty for an early 401(k) withdrawal?

The good news is any money you borrow from your 401(k) is tax-exempt — as long as you pay back the loan on time. If the loan is paid back promptly, interest is the only tax consequence.

And the term “interest” is a bit misleading because you’re paying the interest to yourself — not to a bank.

But keep in mind, it’s a serious problem to take a 401(k) loan while working without having the intent or ability to repay it on schedule.

An unpaid 401(k) loan balance is treated similarly to a hardship withdrawal, with adverse tax consequences and perhaps an unfavorable impact on your ability to participate in your employer’s retirement plan.

Suppose you take a 401(k) loan and then lose, or leave, your job. What happens then?

If you leave your job or are let go, you will have to pay your 401(k) loan back within a few months. Otherwise, it’s considered a distribution, which triggers a 10% tax penalty plus income taxes on the loan balance.

That’s why it’s critical to have a solid plan in place for paying back your loan.

Although borrowers are allowed five years to pay back 401(k) loans, doing so in a year or less is ideal. Pulling funds from your 401(k) early derails your savings efforts for retirement. And until your loan is repaid, you miss out on tax-deferred investment returns on your savings.

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Hilltop Wealth Solutions is a registered investment adviser. This is not intended to be relied upon as investment advice, nor an offer to solicit to buy or sell any securities.