Answered by Tad Borek

It sounds like you're talking about an "in-service withdrawal," which means taking money out of a 401k plan maintained through your current employer. Most plans don't allow in-service withdrawals, so that's something to check first. Can you even do that, or is a loan your only alternative?

Regardless, something to keep in mind with a 401k loan is that the interest paid is just paid to yourself; it's essentially an additional contribution out of your pocket. That makes it different from true investment earnings, which are paid to you from outside sources. While the loan is outstanding, the money taken out isn't earning anything for you.

That said...well, given today's low interest rates, you might not be giving up much income on $5,000 (if it's invested conservatively). A loan at least gives you the option of putting the money back. And if you withdraw funds now, it's a taxable distribution; your tax rate may be higher now, while working, than during retirement. So there are at least a few possible reasons to do a loan rather than an outright distribution. The latter might work out better though, so be sure to understand exactly how the loan works and what the taxes will be in either scenario.

-Tad

February 16 2012