Your employer-sponsored 401(k) is meant to help you save for retirement. But in some cases, provisions may be available for you to borrow from your retirement savings plan, or to make a withdrawal prior to retirement.
While there are some circumstances in which taking a retirement plan loan makes sense, in most cases it's not a very good idea. Here's why:
- You may lower your long-term investment return. By taking out a loan, you lose the earning potential for the loan amount while it's being repaid. And while you are repaying the loan with interest, don't forget that the money is coming out of your own pocket. In addition, depending on your investment selections, funding your loan at a particular time could require that you sell a portion of your investments in a down market.
- You may have to repay the loan immediately should you leave your employer. Most plans require prompt, full repayment when your employment ends. If you are unable to pay off your loan when due, you can be considered "in default." Your outstanding balance will then be treated as a distribution, which means you will have to pay income tax and, if you are under age 59½, an additional 10 percent early withdrawal penalty. Some states may impose additional penalties.
Are you overlooking the alternatives? Other available lines of credit may cost you less in the long run—particularly if you are a homeowner. If you qualify for a home equity loan or home equity line of credit, the interest you pay may be tax-deductible.