Resist the urge to take out a 401(k) loan to pay for Christmas presents

Resist the urge to take out a 401(k) loan to pay for Christmas presents
Eileen St. Pierre, The Everyday Financial Planner

christmas-money-treeAccording to T. Rowe Price, 7% of parents have tapped their retirement accounts in order to pay for holiday spending. There isn’t one financial advisor out there who would ever recommend doing that. Why jeopardize your long-term retirement plans so your kid can get the latest and greatest toy this season for Christmas that will break by mid-January?

Here are the pros and cons of borrowing from your 401(k) or 403(b):

Cons

The most obvious con should be that you are losing out on investment returns. You may also not be able to make any retirement contributions until you have repaid your loan. The bottom line is that you will contribute less to your retirement and have to work longer.

  • Employers, not the federal government, set the terms of your 401(k). Some employers may not allow you to take out a loan.
  • If you leave your job, the loan becomes payable usually within 60 days.
  • If you cannot repay, the loan is treated as a withdrawal and subject to income tax and if you are under age 59 ½, a 10% early withdrawal penalty.

In its guide to 401k loans, 401khelpcenter.com lists 8 circumstances when you should say “no” to 401(k) loans, including:

  1. There is a chance you will lose your job due to a company restructuring.
  2. You are nearing retirement.
  3. You can obtain the funds from other sources.
  4. You can’t pay off the loan right away if you are laid off or change jobs.
  5. You need to the loan to meet everyday living expenses.

Pros

There are times when taking out a loan from your 401(k) makes sense. Examples include:

  • Facing eviction or home foreclosure
  • Sudden uninsured medical expenses
  • Adoption of a child

The common denominator with all these expenses is that they require a significant sum of money in a relatively short period of time. Other common uses of 401(k) loans are to buy a home or pay for college tuition. However, in my opinion, these longer-term expenses can be easily planned for with more appropriate savings plans.

You borrow and repay the money to yourself, not the bank or your employer. This is the most touted reason for taking out these loans – just remember that this does not mean you are profiting from the loan. The loan will not appear on your credit report and the interest rate will be pretty low – generally the prime rate plus 1-2%.

The Bottom Line

Before borrowing, seek financial counseling to understand why you are in this financial situation. Will taking out this loan solve the underlying problem? Or could a 1-3 year savings plan including tax refunds be a better solution?

Make sure what you stand to gain in the present justifies the risk to your financial future!