Is borrowing against your 401(k) ever a good idea?

One of the many benefits available for employees is a company-matched retirement plan, named after the part of the tax code authorizing it. These tax-deferred retirement packages are the principal retirement vehicle for just over half of all people in the United States. Americans often allocate about 6% of their pay in 401(k) plans to take advantage of employee matching contributions and tax breaks.

A lesser-known aspect of 401(k) plans is the ability for account holders to borrow against their accumulated savings. Approximately 87% of funds offer this feature. The account holder can borrow up to 50% of the balance or $50,000, whichever is lower, but the entire sum must be repaid within five years. This feature has garnered popularity among diverse age groups, with 17% of millennials, 13% of Generation X, and 10% of baby boomers having leveraged their 401(k) for loans.

Despite these benefits, borrowing against a 401(k) has some significant risks, including severe penalties for non-repayment and the inherent danger of depleting one's retirement nest egg. It’s a decision that should not be made lightly. 

As with most financial moves, there are benefits and disadvantages to borrowing from a 401(k). Before you make this move, ask yourself these questions:

Will the money fix the problem?

Many borrowers use money from their 401(k) to pay off credit cards, car loans and other high-interest consumer loans. On paper, this might look like a good decision. The 401(k) loan likely has a lower interest rate than a consumer loan that probably has a relatively higher interest rate. Paying them off with a lump sum saves interest and financing charges.

But the question of whether repaying that loan will fix the underlying problem remains. Take a look at your last six months of purchases. If you had made a 401(k) loan six months ago and paid off revolving debt, would your debt load still be a problem? Perhaps not – your current situation may reflect an emergency or an unplanned expense. On the other hand, if your credit cards are financing a lifestyle that is above your means, you may find yourself back in the same position a year down the road — and with no money in your 401(k).

Borrowing against a 401(k) to deal with a medical bill, a first-time home purchase, or an emergency car repair can be a smart move. Using a 401(k) loan to put off a serious change in spending habits is, as one financial expert put it, “like cutting off your arm to lose weight.” Before you borrow against your future, make sure it will really fix your present.

Will the investment offer a better return?

Your 401(k) is earning money for you. It’s invested in stocks, bonds, and mutual funds that are appreciating, usually at a fairly conservative pace. If you pull money out in the form of a 401(k) loan, that steady growth stops.

If you’re borrowing from your 401(k) to invest in a business, ask yourself if your new venture will beat the return you’re currently getting. If you’re planning to pay off your mortgage, compare the interest rate you’re paying to that return. Don’t worry about trying to time or forecast the market. Assuming a 4% return (a safe average) is the most practical course of action.

Is your job secure?

If you’ve recently been promoted or gotten new training on an important job duty, you can be reasonably confident you aren’t going to be let go from your job any time soon. If your recent performance reviews haven’t been stellar, or if your company has some layoffs pending, you might want to beware. If you’re at all hesitant about your future at the company, hold off on borrowing from a 401(k).

If you lose your job or retire with a loan outstanding, you will be required to repay the loan in its entirety. Otherwise, it counts as a “disbursement.” You’re responsible for taxes on the entire amount and you’ll have to pay a 10% early withdrawal penalty, unless you meet one of the IRS exceptions. Staring down big bills like that after you’ve just lost your job is not a fun predicament.

While job loss can happen at any time, you want to make sure you’ll be happy and welcome at your current employer for the next five years before you pull money out of your 401(k). You may also want to consider accelerating your repayment plan to get your 401(k) refunded as quickly as you can. Unlike some loans, there’s no penalty for early repayment. Plus, the sooner the money is back in your account, the sooner it can start earning for you again.

Do you have other options?

If you’ve identified your need for money as immediate, consider what other options you may have available before you dig into your retirement savings. For home repairs, using your home equity line of credit can be a smarter choice. For an outstanding car loan, refinancing may make more sense. For a medical bill, it may be wiser to negotiate a repayment plan with the hospital.

If you’re purchasing your first home, consider the tax implications of mortgage interest. In many cases, you’ll receive preferential tax treatment for interest paid on a home loan. You won’t receive that same benefit from a 401(k) loan.

Borrowing from a 401(k) can be a good way to solve a short-term financial issue. However, it's essential to be aware of the associated risks and consequences for your long-term financial health. More often than not, exploring alternative solutions will prove to be a wiser course of action.