Loans
These days, about 82% of 401(k) plans have loan provisions. That means you can borrow money from your nest egg and pay it back to yourself without incurring penalties. Typically you're allowed to borrow up to half your vested account balance, but not more than $50,000. You have five years to pay back the loan, usually at competitive interest rates, and you can take even longer if the money is going for the down payment on a primary residence.
Most companies don't restrict how you use the money. Better yet, getting it is a snap: There's no credit check since the funds in your account serve as collateral and many of the bigger plans now are automated, so all you have to do is call in your request, and you'll be sent a check in a few days.
You pay interest as well as the principal on the loan to yourself, usually through an automatic payroll deduction. Plans are required to charge a market rate (usually prime plus one or two percentage points), but funds go right back into your account.
Sounds great, doesn't it? In certain circumstances it is. But our best advice is don't do it unless you absolutely have to. The whole point of saving money in a 401(k) is to leave it invested so it will grow tax-free until you stop working. Sure, you are paying yourself interest instead of giving that money to a bank, but if you left your nest egg whole and invested it in equities, you'd likely be making much better returns and the income would compound tax-free. Moreover, if you run into trouble, it's your retirement you put at risk. Say you lose your job or leave for a better opportunity. At that point, the loan becomes due immediately. If you can't pay it back, it's treated as an early withdrawal and penalties and taxes will eat up your savings. Indeed, you shouldn't even consider taking out a loan unless you are very sure you will be in your job for the term of the loan.
When does it make sense? When you need to borrow money and you have no other source. Financial planners note that a disturbingly large percentage of 401(k) loans are used for things like vacations and big-ticket purchases. If you're young and have the self-discipline to pay the loan back in five years, you probably won't damage your eventual nest egg that much. But you do lose five years of compounding and often people overestimate how disciplined they are.
As tempting as it is, you should only borrow from your 401(k) in a pinch -- when you need a down payment for your home or your kids' tuition is due and you have no other source of funds. Even then you should compare other available lines of credit and turn to your 401(k) only if it offers a substantially better deal. Since interest on a home equity loan is tax deductible, that's usually the best way to access credit.
Hardship Withdrawals
If you really want to do serious damage to your retirement goals, consider taking a hardship withdrawal. You'll have to pay income taxes (which run as high as 35%) on the money as well as a 10% federal penalty for early withdrawal.
Also, plans prohibit you from contributing to your account for six months after you make a hardship withdrawal, which may deprive you of receiving company matching funds. All told, withdrawing early with no good reason to do so is about as financially self-destructive as it gets.
Fortunately, it's hard to withdraw the money early if you still work at the company which holds your 401(k). Then, the only way you can access your funds is if you need the money to:
• Pay medical expenses
• Cover the down payment or avoid eviction or foreclosure on your principal residence
• Pay college tuition
• Cover funeral expenses for a family member
Your plan may allow hardship withdrawals for other reasons if you show considerable financial need. You'll have to present documentation proving you have no other assets before your plan can hand over the cash.
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