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3 Reasons a 401(k) Loan Is Better Than an Early Withdrawal

By Maurie Backman - Jun 29, 2021 at 6:48AM

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Need money? Here's why it pays to borrow from your retirement plan rather than raid it with no intention of paying yourself back.

When you need money in a pinch, there's always the option to go to a bank or lending institution and ask for a loan. But why have to beg for a loan when you have money sitting in your very own retirement plan?

If you have a healthy 401(k) plan balance, you may be inclined to take a withdrawal rather than spin your wheels in an effort to borrow money elsewhere. But before you go that route, here's a better option to consider -- a 401(k) loan.

Here's why borrowing against your 401(k) is a more favorable choice.

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Image source: Getty Images.

1. You'll avoid a penalty if you pay your loan back

If you remove funds from a 401(k) before turning 59 1/2, you'll be hit with a 10% early withdrawal penalty. This means that if you take $20,000 out of your account, you'll lose $2,000 of that off the bat. With a 401(k) loan, you won't be penalized unless you fail to repay your loan on time.

2. You're repaying yourself

When you take an early withdrawal from your savings, that money is yours to use, and you don't have to worry about sticking to a specific repayment schedule. That, in turn, could eliminate a lot of stress, to the point where an early withdrawal penalty may, in your mind, seem worth it.

But remember, with a 401(k) loan, you're not paying some institution back -- you're repaying yourself. The money you put back into your account will be yours to access and enjoy during retirement, when you might really need it. That alone should make you feel better about the idea of sticking to a repayment schedule.

3. You may not borrow as freely

Once you make the decision to take an early 401(k) withdrawal, you might adopt a "to heck with it" approach and err on the side of taking out more money rather than less. At that point, you're going to be penalized, so if you're on the fence between removing, say, $20,000 versus $25,000, why not go for the larger sum?

On the other hand, if you take out a 401(k) loan instead of an early withdrawal, you may be inclined to borrow less, knowing you'll need to pay it back. The result? More money gets to stay in your savings, which means you'll have less of a deficit come retirement.

To be clear, it's generally the best practice to leave all of the money in your retirement savings alone until your career comes to an end. And that means avoiding not just early withdrawals, but 401(k) loans as well. But if you're in a bind and raiding your long-term savings reads like your only solution, then a 401(k) loan is generally preferable to an early withdrawal of funds.

That said, if you're going to borrow from your 401(k), read the fine print and make sure you know what you're signing up for. Paying attention to details could help ensure that you stick to your repayment schedule and don't wind up getting penalized inadvertently.

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