When you are faced with a serious emergency, a major expense, or funding a business venture, your nest egg can look tempting to crack.
If you participate in your employer's 401(k), you may be able to borrow up to 50 percent of your vested account balance, up to a maximum of $50,000. Most employers will give you up to five years to repay the loan at a “reasonable” rate of interest—typically one or two percent above the prime rate.
If you only need a short-term loan, you can tap your 401(k) or IRA's balance and avoid both penalties and taxes by rolling the borrowed funds back into an IRA within 60 days.
For certain personal, medical, home-buying, or higher education expenses, special hardship withdrawal provisions allow you to draw from your 401(k) or IRA accounts. Such withdrawals are subject to taxes, but the penalty is waived if you stay within your plan's specific guidelines.
In a real emergency, it's almost certainly better to borrow from your 401(k) than to take a cash advance from your credit card, with its double-digit interest rate, or to borrow from a bank. Taking a hardship withdrawal from your 401(k) or IRA to make a down payment on a home can be a smart move because it should enhance your overall tax situation. You'll be able to deduct the interest on your mortgage payments and build up equity.
If you lack the capital to get a business off the ground, a loan against your 401(k), or a withdrawal—even when a penalty is involved—could make a significant difference to your future. This strategy works best when you are young because you'll have time to catch up on retirement savings once your business is off the ground. If you're over 50, the risk clearly is greater because your timeline is shorter.
Before dipping into your retirement savings, however, consider all of the consequences. If don't repay the loan to your 401(k), you are certain to end up with less in your retirement account at the end of the road. Even if you repay the money—at a higher rate of return than the account would have earned—you will lose out on years of tax-deferred compounding. Because the loan is repaid with after-tax dollars, your actual borrowing costs are higher than they seem.
If you leave your job, or if your company is merged and your plan terminated, you'll be required to repay your loan within two to six months (depending on your plan). If you can't, the loan will be taxed and penalized as an early withdrawal.
Because the rules that govern loans and withdrawals are complex, it makes sense to get professional tax or financial advice before deciding on a strategy.