When money's tight, or when there is something big you need to buy, how tempting it is to think of tapping into your 401(k). Sometimes your retirement plan can look like "found money" -- especially if you have been having regular payments deducted from your paycheck. If you have made smart investments, you may be sitting on a pile of money right now.
Is it a good idea to borrow this money? The short answer is no.
First, remember why you have a 401(k). Congress established these savings plans to encourage us to fund our own retirements rather than rely on Social Security (which isn't enough to fund the retirement of a flea). To entice us to take responsibility for our own golden years, the government allows us to invest pre-tax dollars, which lowers our current tax liability and also permits the earnings to compound tax-free until you withdraw them.
But you are not supposed to withdraw funds until age 59 1/2. And if you take your money out sooner, you will be slapped with penalties -- and taxes. In most cases, you will be hit with a penalty of 10 percent of the amount you withdraw. On top of that, you will pay taxes at ordinary income-tax rates on your capital gains (the amount your money has grown). That can all add up to a hefty sum.
However, you can withdraw the money early and not pay any penalty under certain circumstances. The two main exemptions are for the down payment on a first home and major medical expenses. You may, for example, withdraw up to $10,000 for your down payment without paying a penalty. (This is not a loan. Your account simply becomes $10,000 smaller.) If you have lost income because of a disability, you may also qualify for a penalty-free withdrawal. If you have questions about specific situations, you can get detailed information from the IRS.
You definitely do not want to borrow from your tax-deferred retirement plan to buy a car or to pay for an education. Why? Because there are cheaper ways to get this money. For a car, the interest on a loan from a dealer is lower than the taxes and penalties for borrowing from your 401(k). The same goes for student loans, which charge a pretty reasonable average interest rate of about 8.25 percent. What is more, during the first five years that you repay an education loan, the interest may be tax-deductible up to $2,000 a year. (That break is for single people with adjusted gross incomes up to $40,000, and $60,000 for couples' income filed jointly.)
No Loans, Please
Depending on the rules of your company's plan, you may be allowed to take out a loan from your 401(k) account. But "borrowing" from a 401(k) to pay off credit card debt is a bad idea.
Credit card debt is unnerving, because it compounds, growing larger and more devastating with each passing day. If you take a loan from your 401(k) to pay off your debt, you are required to repay the loan over a five-year period. But think about this: If you lose or leave your job, you may have to repay the amount immediately to avoid having it treated as a withdrawal -- in which case, you'd owe taxes on it plus a 10 percent penalty.
And if you cannot pay off your debts now, what makes you think you can pay off another debt later? In the case of a loan from a 401(k), it is likely you will not get it paid off in time and will not only have to pay the penalties but will have lost the income growth on the money that would have occurred in the meantime. In most cases, it is a far better idea to cut up your cards and set up a plan to repay your creditors.
By far the best reason not to touch your retirement account is to remember that you will probably live a long life. No matter what you tell yourself, it is virtually impossible to rebuild your retirement savings. Do not make the mistake of destroying one of the few financial sure things that you do have.