In times of economic downturn many people who need cash feel that their 401(k) is their money so borrowing from it is a better option than personal loans. However, this may not be the best idea. In fact, it could be financially unsound and carry problems long into the future.
Borrowing from a 401(k)
When you borrow from your 401(k), the account manager gives you the money out of your account. This has a few pitfalls. First, you will be subject to the tax liability for withdrawing funds. Additionally, your retirement account immediately takes a drop and thus cannot produce the desired increases that it would produce had the money stayed in the account. If that were not enough, you could face tax penalties as well. The additional penalties occur when the borrower unexpectedly loses their job and is forced to pay back the entirety of the loan within 60 days. When this does not happen, the amount becomes taxable and penalties of up to 10 percent occur.
How Personal Loans are Better
Since a personal loan is not a secured loan (in most cases), the interest rate on the loan will be higher. However, the loan will not have any deleterious effects. You can safely borrow any amount needed and take several years to pay back the loan. There are no additional taxes or penalties assessed for borrowing, and payments will remain the same despite your employment status. While no one likes to think of losing a job, the unexpected happens. When you choose a personal loan, paying back the loan is much more difficult without a job, but at least you will not be suddenly out of a job and be required to pay back the entire loan immediately.
The Best Option: Build an Emergency Fund
Your best option is to build an emergency fund while you are also putting money in your 401(k). It takes discipline and practice to set aside money for emergencies but it is the most financially sound decision. Ideally, you will want to save up six to twelve months of income. This money can then be used for emergency situations (i.e. fire, theft, ER visits) or in the event of unexpected job loss. In the current economy, it is taking the average job seeker three months to find a new job with an extra month for every $10,000 over $50,000 made. Therefore, if you make $70,000 a year, it is taking approximately five months to find a new job.
While dipping into your 401(k) may be tempting, it is a risky option. Instead, check out personal loans and then start building an emergency fund so you will be better prepared next time.