Unfortunately, one of the places people sometimes go for emergency cash needs is their 401(k). Most people know they probably really shouldn't touch that money, but they rationalize taking the withdrawal by saying that they are at least paying interest to themselves. Plus, taking a loan from the 401(k) is fairly easy. There is no actual application (so no credit check, etc.) and most employer plans allow you to take a loan for up to 50 percent of your vested account balance, subject to a maximum loan amount of $50,000. Also, the interest rates are usually quite low.
However, taking a 401(k) loan is almost always not the best solution. For starters, you need to remember that any money you borrow is not growing. As soon as you take a loan, you are losing out on the capital gains, interest and dividends that the money would have earned. It is a well known fact that most people are not saving enough for retirement and when a person starts viewing their 401(k) as a back-up piggy bank, the odds are good that are not committed to saving enough to ensure their retirement security. Furthermore, you really need to be prepared the loan in full at any time. If you fail to repay the loan, it will be considered a premature distribution and taxes are due on premature distributions. In addition, if you are 59 and a half and younger, a 10 percent penalty would be imposed. You might think that you have plenty of time to re-pay the loan but if your employer were to lay you off, the loan would become due in full. It is important to consider all of these points when deciding to take a loan from your 401(k) and if you can possibly avoid withdrawing from the plan, that is almost always the best course of action.