Should federal employees consider taking a retirement plan loan to cover their expenses during the government shutdown? In a recent episode of her podcast, Suze Orman said that this is the first time she’s recommending this move. Is she right? Should federal employees and even other employees in similar situations consider borrowing from their 401(k) to cover expenses in an emergency? Let’s take a look at the pros and cons:
Pro: There’s no credit check. For someone with poor credit, this could be their only option. Taking a 401(k) loan doesn’t hurt your credit (or help you build it) either.
Con: Defaulting can cost you taxes and penalties. The reason there’s no credit check is because it’s not a typical loan from a creditor. Instead, the IRS allows you to borrow your own money with the caveat that if you don’t pay it back (usually through payroll deduction and some but not all employers allow you to continue making payments after you leave the job), the outstanding amount will be considered a withdrawal that’s subject to taxes plus a possible 10% penalty if you’re under age 59 ½. You also can’t discharge a retirement plan loan through bankruptcy.
Pro: You pay the interest back to yourself. This is probably the biggest advantage. Unlike other forms of debt, the interest you pay just goes into your own account. This is also the reason why it may make sense to use a retirement plan loan to pay off high interest debt like credit cards (as long as you don’t run those credit cards back up again).
Con: There are costs. As they say, there’s no such thing as a free lunch (or loan in this case). First, these loans typically come with fees. Second, you lose any earnings you would have otherwise made on that money, which can be more than the interest you would have paid on a low interest home equity loan or line of credit. Finally, you pay the interest with after-tax dollars and then pay taxes on the interest again when you withdraw it, essentially paying double taxes on that money.
So what’s the bottom line? It depends on why you need the loan and what the alternatives are. As Orman points out, you need to prioritize basic essentials like keeping a roof over your head, your vehicle in the driveway, gas in the tank, food on the table, and the electricity and water running if you’re not getting paid (whether because of a government shutdown, a period of unemployment, or wage garnishment). You may also want to use a retirement plan loan to refinance high interest debt (like credit cards or payday loans) or to avoid defaulting on debt payments and ruining your credit.
But even if you need the money, make sure you consider other alternatives. Ideally, you’d have savings you can tap into. (This is why financial planners generally recommend having enough emergency savings to cover at least 3-6 months of living expenses.) If not, here are a few alternatives to consider: