Employer-sponsored 401(k) plans may have various loan provisions allowing participants to take loans against their retirement savings or take withdrawals in times of hardship. But before you consider borrowing money from your 401(k) plan, you will need to understand how your loans and withdrawals will affect your retirement goals and savings and what tax consequences you may trigger.

Many 401(k) participants make the mistake of tapping into their retirement savings when they need some cash. Unless you absolutely need it to meet short-term liquidy crunches, you should avoid withdrawing or borrowing against your 401(k) because its main purpose is to save for your retirement needs and goals for the future. If you make a habit out of taking money out of your 401(k) from time to time without even noticing it, you may run the risk of depleting your retirement assets before you retire. Additionally, depending on how you take the money out, you may face additional tax consequences and penalties for early withdrawals before the age of 59 1/2. However, when you need the money, you need the money, so if an emergency arises such as a college tuition bill from an Ivy League school, and your 401(k) plan is the only area where you can rely on to cover the educational expenses, borrowing from your 401(k) or outright withdrawing funds may be your sole option.

Plan loans

Contact your plan administrator or read your 401(k) plan documents provided by your employer to check if you are allowed to withdraw or borrow money from your 401(k) plan and what reasons would constitute an eligible circumstance. Some employers will set the 401(k) contract terms to only allow 401(k) loans in cases of financial hardship, and some may allow you to borrow money to buy your first home, buy a car, or for some other purposes.

Typically, getting a 401(k) loan is simple. There isn't a stack of papers to sign or credit check to go through. The fees are negligible, which at most may include a small processing fee, and that's about it.

How much can you borrow?

Generally speaking, even if you want to take a 401(k) loan, you are usually restricted by the retirement plan to borrowing no more than $50,000 or one-half the amount vested in the plan, whichever is the smaller amount. So you can't borrow the entire sum.

What about repaying the loan?

Generally speaking, like any other loan, you will have to repay the loan you've borrowed from your 401(k) within five years. This will include payments at least quarterly to satisfy the two parts that make up the loan which are principal and interest. There are certain exceptions, for instance, if you borrowed the funds to purchase your home, you may obtain an extension on the repayment of the loan.

Complying with the repayment requirements of your loan is important. If you don't follow the instructions set out in the terms of the loan, the loan money will be considered as a taxable distribution which will trigger ordinary income taxes and a 10% early withdrawal penalties if you're under 59 1/2.

Advantages of borrowing money from your 401(k)

•There aren't any taxes or penalties on the borrowed amount as long as you stick to the loan repayment schedule.

•Interest rates on 401(k) loans must be in line with the rates charged by banks and other institutions for similar loans.

•The interest that you pay on your borrowed money is usually credited to your retirement plan account, so essentially you pay interest to yourself, not a bank or a lender.

Disadvantages of borrowing money from your 401(k)

•If you don't repay your loan that you borrowed from your 401(k) plan according to the terms of your loan agreement, then the loan will be treated as a taxable distribution.

•If you stop working for your employer, whether you're laid off or quit, and you still have an outstanding balance on your 401(k) loan, you'll be required to satisfy the loan in full within 60 days. Otherwise, the balance will be treated as a taxable distribution and you may also owe a 10% early withdrawal penalty in addition to the income taxes.

•Loan interest is not tax deductible.

•Loan payments must be made with after-tax dollars.

Hardship withdrawals

Most 401(k) plans have provisions that allow you to withdraw money if there are severe financial hardships and you have no other way to obtain funds. Many employers have general circumstances that warrant hardship withdrawals such as:

•Paying medical expenses of you, your spouse, your children, or any other dependents.

•Paying funeral expenses for your parent, your children, or any other dependents.

•Paying tuition and related educational expenses for you, your spouse, your children, or any other dependents.

•Paying costs associated with your home such as to avoid foreclosure or eviction or to repair home damages.

What are the advantages of withdrawing money from your 401(k) in cases of hardship?

It comes in handy to have the ability to withdraw money in case of financial hardships especially if you have no other ways of obtaining the funds that you need, and, moreover, if your current 401(k) plan does not allow for loans.

What are the disadvantages of withdrawing money from your 401(k) in cases of hardship?

•Taking hardship withdrawals will deplete your retirement savings.

•Hardship withdrawals are subject to ordinary income taxes.

•You may be prohibited to contribute to your 401(k) plan for at least 6 months after taking a hardship distribution.