Despite best-laid plans, it’s not unusual for people to suddenly be hit by a major car repair, medical bill or other expense they are financially unprepared to cover.
In fact, a recent report from the Federal Reserve revealed a disturbing statistic: About 40 percent of Americans can’t even cover an unexpected expense of as little as $400, much less a dire emergency that runs into thousands of dollars.
So people usually pay those unplanned expenses with a credit card, a bank line of credit or even by borrowing from family or friends.
But there is an another option many of them might not think about – or even realize is available. Most people who have a 401(k) account can borrow from it.
It’s definitely worth considering if a major expense suddenly rears up, but before you take this drastic step, let’s take a look at a few things you should know.
- A 401(k) loan should be your last resort. If you have other options – just about any other option – go with those first. For so many people, a 401(k) is the linchpin of their retirement planning. Start eroding it and their entire retirement is placed at risk. Many of my clients have been contributing to a 401(k) for years, trying to save a solid nest egg to cover expenses when they are no longer working. When you borrow from that account, you’re taking away from your total amount of funds until you pay the money back, which means you are missing out on some investment earnings.
- How the process works. Even though it’s your money you’re borrowing, you don’t get to set the rules for the loan. A mixture of IRS regulations and your plan’s own rules come into effect to determine the conditions of the loan, including the interest rate, the payment terms and the amount you’re allowed to borrow.
- A 401(k) loan does come with advantages. If you’ve decided to move forward, it is worth noting that there are indeed advantages to borrowing from your 401(k). You are borrowing from yourself, so you are paying yourself back – with interest. Usually, there aren’t as many documents to fill out as there would be with a bank loan, so the process tends to be relatively quick.
Borrowing from a 401(k) isn’t something to take lightly. You’re borrowing from your retirement nest egg and plenty of complications (and penalties) could arise if you change jobs or fail to pay back the money on time.
But if your emergency situation is dire enough – and you’ve exhausted other possibilities – then a 401(k) loan is worth taking a look at, preferably with some consultation from your financial professional.
Christopher J. Dixon, a managing partner with Oxford Advisory Group, is a Registered Financial Consultant. He specializes in tax-free retirement strategies, executive compensation and business-exit strategies.
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