I have mixed feelings about 401k loans (or other types of retirement account loans like TSP loans or 403b loans).
For some they can be a savings grace in a bind but they are often misused.
We all know that unexpected things happen in life and ideally none of us would ever have to touch our retirement savings to cover these emergencies.
But because life is often not ideal, there are certain times that a 401k loan might just be the best option even with the negative consequences.
One Last Check
Before truly considering a 401k loan, make sure to do one last check that you don’t have any other funds that you can use.
Your 401k should be one of the very last places to go for money.
When money is taken out of your 401k it can no longer grow and compound over time which can severely lower what your 401k balance could be at retirement. Also, if a 401k loan is not fully paid back by the time you leave your job then it may be counted as a taxable distribution.
So you may not want to take a 401k loan if you are leaving your job in the near future.
Paying Off High-Interest Debt
The first situation that it may make sense to use a 401k loan is to pay off high-interest loans such as credit cards.
In many cases, credit card interest can be 15%-20% while the interest rate on 401k loans are typically very low. Not to mention that any interest that you do pay on a 401k loan just goes back into your account.
But like always, we will want to make sure that we are solving the underlying problem and not just fighting symptoms. If our spending habits keep putting us into credit card debt then pulling from your 401k will only be a short-term fix.
I would only consider using the 401k for debt when you are fully committed to not accumulating more credit card debt.
Medical Emergency With HDHP
A high deductible health plan or HDHP can be a great way to save money in premiums but as the name suggests the deductibles are high.
This means that some people may be caught without the savings to cover the deductible when a medical event happens in their family.
The best way to pay the deductible in a high deductible plan is with an HSA or health savings account because of its great tax advantages. But for those that don’t have an HSA and don’t have the savings, a 401k loan may be the next best option so that they can preserve their credit.
Bad Credit
Emergencies often occur when we least expect them and some people may be caught financially unprepared. This can be even more stressful if bad credit prevents you from getting a loan at a reasonable rate.
In these situations, it can sometimes make sense to access your 401k to avoid more high-interest debt.
But as always, we should always do whatever we can to not put ourselves in this position in the first place.
For those with good credit, a HELOC (home equity line of credit) may be a better alternative to a 401k loan.
Another Reminder
As a general rule, I don’t recommend a 401k loan unless it is really needed but in some circumstances it can be a great tool to provide flexibility in tough times.