It’s great to have a 401(k), but not everyone knows that you don’t have to wait until you’re retired before they become useful. There are a number of reasons you can take cash from your retirement account. It’s basically taking out a loan from yourself. Funds from a 401(k) can be used to pay for a myriad of things, from medical expenses to financing a business to buying a home — although there should be a smart reason to take a loan. No vacations or big-screen TVs.
Among the benefits of borrowing from a 401(k) is that you can set the length of the loan. Forbes.com recommends a short-term limit, such as a year or less. In addition, the interest rate (which is repaid to the account) can be much lower than the rate of other consumer loans, especially for those with little or no credit history. Also, there is no credit check and the loan isn’t taxed.
A major drawback to borrowing from your 401(k) is that your retirement account will stop growing, so you miss out on valuable interest gains. Bankrate.com offers a retirement loan calculator to see how much you could lose. Also, make sure your job is secure before taking out the loan. It must be paid off immediately if your employment ends or upon retirement. If you don’t repay before retirement, you could be slapped with a 10 percent federal tax penalty.
Hardship withdrawals are another financing option. They are funds taken out of your 401(k) that do not need to be repaid. These are best used for pressing financial needs or when you have exhausted other money sources. There are restrictions on what the money can be used for. These reasons can vary by employer; some plans don’t allow using the funds to buy a home or repay tuition, while other plans allow those uses. In addition, there is usually a period of six months or longer where no contributions to a 401(k) can be made after a withdrawal, so there will be a little extra cash in your paycheck.
For hardship distributions, the major consequence is that the money may be subject to additional taxation. It helps, though, that the money to repay those taxes can be included in the hardship distribution. You must also go through the process of demonstrating a financial need for the withdrawal to be approved. You’ll also miss out on more valuable account growth with this option.
Both loans and withdrawals have limits on the amount that can be taken. The IRS offers specific guidance on what those limits are for loans. Check your employer’s 401(k) plan information to find out the limits on how much can be withdrawn. Usually there is a percentage that can be taken out based on how much you have contributed to the plan, and sometimes you can take out only enough to cover the exact amount of the bill or expense you are trying to pay.