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Is it better to break into a CD or a 401(k)?

September 25, 2014

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

401(k)

Q: I am facing a financial emergency where I need to get my hands on $10,000 in cash in a hurry. I have more than that in a CD, but it's not due for another two years. One option would be to pay the penalty to break into that CD. Another might be to borrow against my 401(k) balance, which is well in excess of $10,000. This might be a better option because there is no penalty involved. Which do you think would make the most sense?

A: Most likely, breaking into your CD is going to be the most cost-effective and straight-forward option, though of course that depends on the specific CD terms. First though, here are two reasons why borrowing against your 401(k) plan might not be the best course of action:

  1. Loss of tax-deferred earnings. Between the time you borrow from the plan and when you repay the money, the loan balance will be out of the plan. This means that you will miss out on some investment earnings during that period, which is especially damaging since those earnings are tax-deferred.
  2. Repayment requirement. Loans from a 401(k) plan must be repaid within five years, so you have to ask yourself: If your need for immediate cash is so great, will you have the liquidity to meet that repayment schedule?

You would need to make sure that your 401(k) plan allows loans, and if so under what terms. If you do borrow against your 401(k) balance, it is very important that you do this pursuant to a formal, written agreement. Otherwise, your receipt of the money might be deemed a taxable distribution. That could mean that you would have to pay income tax on the amount of the loan, and possibly a 10 percent penalty.

In contrast, the penalty for early withdrawal from a CD is often just a matter of three to six months of interest. The best CD rates these days are just above 2 percent, so suppose you have a CD with a 2 percent rate and face a six-month interest penalty. Effectively, it would cost you about 1 percent to get out of your CD. If you have had the CD for a while, the penalty might be even less, because some CD penalties diminish over time.

Be sure to check the specifics of your CD before making a decision, but if you really need the cash, a 1 percent penalty may well be a more cost-effective solution than disrupting your long-term retirement program. This is also a good reminder of the benefit of keeping an emergency reserve in savings accounts or money market accounts, which will make your money more accessible in situations like this.

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