Questions to ask before borrowing from a 401(k)

When you're up to your ears in debt but have a lot of money in retirement savings, taking an early withdrawal from your 401(k) can be tempting.

Most of the time, though, it's a big mistake, says Guy Baker, NerdWallet advisor and managing director at Insight Wealth Solutions.

"People can't confuse their put-and-take machine with their long-term savings," he says. With taxes, penalties and the loss of compounding interest, he notes, even a small withdrawal from a tax-advantaged account could end up costing a bundle.

But many people do it anyway. When changing jobs, one in three workers chose to cash out their workplace retirement savings, according to a 2014 analysis by Fidelity Investments, which manages the most 401(k) plans in the U.S.

Don't make a mistake that could cost you your whole retirement. Before taking out a 401(k) loan, liquidating your retirement savings or requesting a hardship withdrawal, ask these questions:

How much money am I losing?

Take a $10,000 loan from your 401(k), and you might think it's just that — $10,000. But it's actually worth a lot more.

"When somebody wants to pull money out of their retirement account, it's not just costing them what they pull out," says Baker. "It's costing them what it would grow to and the tax it's going to cost them to repay it." Assuming 7.2% growth each year, he adds, it would double every 10 years — and those who borrowed from their accounts would miss out on those gains.

There could be other costs, too. With a 401(k) loan, you can borrow up to 50% of your balance or $50,000 — whatever's less — and pay it back within five years. But lose your job and you might have to repay the loan a lot sooner than planned. If you couldn't repay it on time, you could end up shelling out a 10% penalty and income tax on your earnings, driving up your costs.

For other early disbursements, such as hardship withdrawals or cashing out your plan when switching jobs, you'd likely have to pay a 10% penalty as well, with some exceptions . The influx of money might also put you in a higher tax bracket.

Can I get back on track before retirement?

Before borrowing from your retirement savings, consider your long-term goals. If you take from your retirement funds now, will you be able to catch up later? For many people, the answer is no.

"Even though it may seem like taking just a little out of a big retirement savings pot will do no lasting harm, quite the opposite is true," writes Andy Tilp, NerdWallet advisor and president at Trillium Valley Financial Planning, in an e-mail.

If someone withdrew $50,000 from retirement savings before age 59½, assuming a 25% income tax rate and a 10% penalty, the person would end up paying $17,500 in fees and taxes — so he or she would only be able to use $32,500, he says. In contrast, had that $50,000 been left in the account, it could have grown to $100,000 in about 10 years, assuming a 7% growth rate, he notes.

Getting your savings back up to that theoretical $100,000 in just a few years isn't easy. The closer you are to retirement, the harder it is to make up for that lost time.

Are there better alternatives?

Tapping into your retirement savings should be a "last resort," says Johanna Fox Turner, NerdWallet advisor and senior partner at Milestones Financial Planning. Before looking to your 401(k) or IRA for money, consider other options, like borrowing from family and paying them back with interest, she says.

"If you have a good relationship with your parents and you're a good money manager, it's a really good option," she says. "But the important thing is to make it a business transaction and keep feelings out of it." Home equity loans or home equity lines of credit (HELOCs) could also be better alternatives to borrowing from an IRA or 401(k), she notes.

If you really feel that using your retirement savings early is your best choice, talk to a financial advisor first, says Turner. An appointment might cost a couple hundred dollars, but if it prevents you from making a $50,000 mistake, it could be well worth it.

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