A 401(k) is meant for retirement, so pulling money out of your account before you finish your career is typically a bad idea.
There are some big drawbacks to taking money out of your retirement savings. First, you might owe taxes. The government could also impose a penalty if it's not for a qualified purpose. Second, you'll miss out on the opportunity to grow your account balance by investing the money you withdraw.
But sometimes there are no other options, and that pool of money you've saved and invested over the years can provide an effective lifeline to make sure you get to the finish line after all. Here are three cases where it might actually make sense to tap your retirement account for cash.
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1. Down payment on a house
Getting the cash together for a down payment can be difficult sometimes, but you might use your 401(k) to help out.
If your 401(k) has a loan provision, that's an ideal way to raise additional cash for a house down payment once you've exhausted all other options. That's because using a loan won't affect your taxes, and you'll be able to put the money back into the account later to allow it to grow. While you'll have to pay interest on the loan, it's interest paid to yourself.
You can borrow up to $50,000 or half your vested balance, whichever's smaller. While that might not cover an entire down payment, it could put a big dent in it.
The 401(k) loan can be a great option for managing cash flow in your personal finances. The added liquidity can help you qualify for a better mortgage, and it could be a big money saver in the long run if you get a lower interest rate and avoid private mortgage insurance. As long as you know there's room in the budget to pay back the loan and the new mortgage note, it can work out very well.
It should be noted, however, that many 401(k) plans will prevent you from making contributions until your loan is repaid. That may mean you're unable to collect your employer match while you repay your loan. Additionally, if you separate from service before repaying the loan, you'll have to repay the balance by the date your taxes are due. Otherwise, you usually have five years to repay the loan.
2. Investment opportunities
A 401(k) has limits on what you can and can't invest in, so a 401(k) loan may be useful for taking advantage of short-term opportunities not available within the 401(k).
Some opportunities are expressly forbidden in a 401(k). These include buying a property for personal use or use for a family member or other disqualified person. You also cannot lend money to a disqualified person like a spouse and have them pay you back with interest. You cannot buy art or collectibles in your 401(k), and most coins are forbidden as well.
If you have an opportunity with a high degree of confidence to produce strong returns and you don't have any extra money to invest in the opportunity, a 401(k) loan may make sense as a way to access the cash needed for the investment.
3. Black swan events
If you face a black swan event -- an unpredictable event beyond normal expectations -- that causes you financial stress, you might be able to use funds in your 401(k) to make it through.
For example, if you or someone in your family have a medical treatment costing thousands of dollars that your insurance is refusing to cover for some reason, a loan from your 401(k) could give you the liquidity you need. Likewise, you can borrow 401(k) funds in the event of an unexpected death in your family that forces you to incur funeral and other costs.
The last line of defense
Ideally, you'll never have to touch the money in your 401(k) until retirement, and those funds should be thought of as a last resort to avoid disaster or make the most of an opportunity.
There are many advantages to saving and investing within a 401(k), but that doesn't mean you should put all your money into the account. Once it's in there, it can be very expensive or burdensome to get out, and you may close off opportunities in the future. The best strategy for financial flexibility is to save money in several different types of accounts.
While it's not to be relied on, it's worth remembering that a 401(k) can provide a backstop to help you through financial bottlenecks and seize opportunities you may face during your career.
