by Christy Bieber | Feb. 26, 2019
Your retirement savings is intended to be used to provide you with a secure future as a senior. In order for it to do that, the money you've invested should be left to grow. Taking money out early can reduce the amount of compound interest the money earns. And, if you take out funds from a tax-advantaged retirement account such as a 401(k) or IRA before you've reached retirement age, this could trigger hefty taxes and penalties.
Because of the big costs associated with early withdrawals from a retirement account, this should essentially never be done unless it's a dire emergency or you qualify for a hardship withdrawal. Of course, even if you qualify for a hardship withdrawal -- which can happen if funds will be used to prevent eviction or foreclosure; to pay funeral or medical expenses; or for another designated purpose allowed by the IRS -- you're still risking your retirement security by taking money out for good.
You don't want to pay penalties or put your future at risk, so if you have to tap into retirement savings, the smartest way to do it is usually with a 401(k) loan. A 401(k) loan is a loan you make to yourself from your 401(k) plan, if your plan allows it. While there are still some downsides to taking out a 401(k) loan -- including the risk of triggering penalties if you can't pay it back -- there are also three reasons this option is worth considering. Here are those three reasons.
If your plan permits a 401(k) loan, getting the loan is typically pretty simple. Unlike with a personal loan or a home equity loan, a lender doesn't have to assess your financial situation to determine if you qualify. Since you're tapping into your own retirement account by borrowing against it, there's no need to prove you're credit worthy. You just have to fill out some paperwork with your plan administrator.
Generally, you're permitted to borrow the lesser of 50% of the value of your account or $50,000 but guidelines can vary based on your plan. Your plan may also restrict you to taking out a 401(k) loan only for specific reasons, although most employees are allowed to borrow from their plan for anything they want.
You'll need to talk with the plan administrator to find out exactly what the rules are and how to request a loan, but often you can just fill out the application online and will get your funds pretty quickly.
Interest rates on a 401(k) loan also vary by plan. But, in general, rates will be lower than the rate on a personal loan and will be much lower than credit card interest. The less interest you pay on your debt, the more of your money goes toward principal and the faster and easier you can pay back what you owe. And, a lower interest rate also means more affordable monthly payments, which gives you more wiggle room in your budget.
Because interest rates are so low on 401(k) loans, many people use these types of loans to pay off other higher interest debt. If you're trying to become debt free, a 401(k) loan could allow you to pay off a bunch of credit cards and dramatically drop their interest rates. You'd just have the 401(k) loan to pay instead of multiple credit card lenders, and far more of your payment would go to actually reducing your loan balance instead of paying interest to enrich your creditors.
Not only is the interest rate on a 401(k) loan low, you're paying interest to yourself when you use a 401(k) loan to tap into retirement savings. That means you aren't wasting money on interest at all, but instead are contributing it to your retirement account where the money can be invested for the future.
As you can see, there are some big benefits to taking a 401(k) loan, including reducing your interest rate and paying interest to yourself instead of a creditor. The easy qualifying requirements and ability to get your money quickly can also make 401(k) loans attractive in an emergency. But, there are serious downsides to think about too, including the fact your money won't be invested and working for you and the risk you'd be hit with penalties for early withdrawal if you don't pay your loan back as planned.
If you must tap into your retirement savings, a 401(k) loan is definitely the smarter way to do it. A hardship withdrawal means you won't have the funds in your retirement account and will have to live on less as a senior, while paying penalties for early withdrawal is definitely a bad idea. However, just because taking a 401(k) loan is better than these alternatives doesn't always mean it's the right move.
Unless you really need the money, or are serious about paying down debt very quickly and think a 401(k) loan can help you, you should try to leave the funds invested for your future.
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