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Why it’s a Risky Idea to Raid Your 401K in this Economy

With the recession, loss of jobs, and unwillingness of banks to give out loans like they used to, many Americans have turned to their 401K for a loan. Aside from the fact that I cringe at the thought of taking money away from retirement—even at the young age of 29, even though I know it will be paid back with interest—raiding a 401(K) account in this economy is too risky. Let me explain why.

This must look like a pretty decent option to many as a 401(K) is your money, and even though you pay interest on it, the interest goes back into your account. I, and most others, probably wouldn’t be upset about paying interest if it comes back to me.

Job Loss with an Outstanding 401k Loan

But what makes this a particularly precarious thing to do right now is the job situation. We have been at 9%+ unemployment for a few years and just came under 9% in the past few months and the debt crisis in Europe would make me think twice. Perhaps your job is stable, but in this economy, how do you really know?

Loan due immediately. If you took out a loan on your 401(K) and lost your job for any reason, the money becomes due within 60 days — even if your position was eliminated and you were laid-off through no fault of your own. We are at the point where it is more likely than it used to be that businesses will cut down on positions. Take it from a person who was laid off in her first two jobs [1] out of college in a good economy—this is too risky of an option.

If you can’t pay it back. When you can’t pay back the loan within 60 days—and chances are good you won’t be able to as you did not have that money in the first place and now you don’t even have an income—the outstanding loan balance is taxed and penalized as a premature distribution [2].

Loss of compounding. Worse yet, you then cannot put the loan balance back into your 401(K) account. Since there is a limit of the amount of money you can contribute annually [3] to your 401K ($17,000 in 2012) and you cannot make catch-up contributions [4], you have lost years of compound interest on your loan amount. If you are young, the amount of money you have lost by the time you are ready to retire can be staggering.

Alternatives for Emergency Financial Situations

The trouble with writing a post like this is I want to be able to offer you a more financially sound solution than to borrow from your 401(K). But this is difficult to do! I am assuming that you do not have an emergency fund, or you would have used that by now. If you have good credit and are financially disciplined, then you could charge it to a credit card and do a 0% balance transfer [5]. You will need to pay this money back within 12 months or whatever the terms are for your particular offer, but at least this will buy you some time. Borrowing from family and friends can cause its own problems as far as changing the relationship dynamics between you and the person who is giving you the money. However, it is an option.

What other options do you know of to get cash for an emergency situation besides raiding a 401k? 

More Retirement Planning Questions