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There are only 3 situations when it 'makes sense' to borrow from your 401(k), experts say

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While it's generally a bad idea to dip into your retirement savings early, there are certain situations when borrowing from your 401(k) ahead of retirement "makes sense," Catherine Golladay, president of Schwab Retirement Plan Services, tells CNBC Make It.

"Generally speaking, people should only borrow from their 401(k) as a last resort," Golladay says. However, "it could be the right move if you don't anticipate any changes to your job situation and you're still on track for retirement overall."

Should your circumstances warrant doing so, requesting money from your 401(k) is "a much simpler process than applying for an external loan," Golladay says. But keep in mind that when you pay it back, "you are paying the principal and interest on the loan to your own account."

While Golladay says this essentially makes the loan "interest-free," what she means is that the 401(k) repayments are paid by the borrower back into their own 401(k) account, rather than to a third-party such as a bank. You're still paying interest for borrowing the money, but it's going back into you. As long as you can keep up the ongoing payments without defaulting, this interest model can be a nice perk — but remember, all 401(k) loans must be paid back within a five year window.

While you should pay attention to all of the potential downsides of taking a loan from your 401(k), as well as have a realistic plan for paying it back if you do, there are three times when it may make sense.

1. To make a down payment on a home

Buying a home is a big expense, and as a result, more than 10% of Americans have dipped into their retirement savings in order to make a down payment on their first home, according to Bankrate.

That's not necessarily a bad thing: "There are certain circumstances in which taking a 401(k) loan might make sense, such as making a down payment on a home, which is a worthwhile financial goal in its own right," Golladay says.

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If you choose this option, it's important to "ensure the size of the loan doesn't keep you from continuing to save for retirement," Golladay says. You want to be able to keep saving in addition to paying back the loan.

When determining how large of a loan to take, "less is more," says Ryan Marshall, a New Jersey-based certified financial planner. "The maximum 401(k) loan amount generally is 50% of the vested balance or $50,000, whichever is less," he explains. However, "I would say try to keep it to 10% of the portfolio or $10,000."

Another thing to take into account is the housing market. In general, you should always ask yourself whether you're planning to buy within "a favorable market for purchasing real estate," Golladay says. Is it worth buying now, or should you keep saving up as you wait for better market conditions? 

2. To pay off high-interest debt

Paying down high-interest debt is another potential reason to take a 401(k) loan, Golladay says.

That's because the prime rate, or the interest rate banks charge on loans, is currently 5%, Marshall says. The interest 401(k) borrowers pay themselves back typically sits just one or two points above the prime rate, which is a lot better than the 19% to 20% some high-interest credit cards are charging, he explains. 

However, before taking a 401(k) loan to pay down debt, you should exhaust all other options, Marshall says. That includes earning extra money by getting a side hustle or part-time job, or selling old belongings.

"There are so many other ways to pay down high-interest debt and I never recommend withdrawing from your retirement until all other options are exhausted," Marshall says. But, if absolutely necessary, he recommends you take a 401(k) loan, instead of a 401(k) hardship withdrawal, since the two come with varying terms.

"There are some 401(k) plans that allow you to take a loan against the account versus taking a withdrawal. With a withdrawal, it becomes taxable and there is the 10% penalty," Marshall explains. "However, when you take a loan, you are basically borrowing from yourself and there is no tax implication for this transaction."

3. When you are in serious financial need

Sometimes, it makes sense to take a 401(k) loan when you are in a temporary period of financial need and have to cover expenses until you return to a more secure situation, Golladay says.

"Picture a scenario in which one spouse is let go from their job and the family is having trouble making ends meet on one income," Golladay says. "The employed spouse might borrow from his or her 401(k) to cover the gap, and then pay that loan back promptly once the other spouse finds a new job."

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If it's a specific need you are trying to finance, such as permanent disability or medical bill coverage, 401(k) plans typically offer withdrawal waivers where the additional 10% tax you'd typically be charged on the withdrawal is waived.

"There are different exceptions that qualify for a 10% early withdrawal waiver," Marshall says. "I recommend finding out if you qualify for the waiver and using funds out of the proper account to fund your need."

Factors to consider before borrowing from your 401(k)

Be aware that there are consequences that could potentially come with raiding your 401(k) early. For one, taking out money prior to retirement (or before the age of 59½) often results in penalties and fees.

Even if you take a loan that you plan to pay back, the pre-tax money you borrow from your 401(k) will ultimately have to be repaid using after-tax dollars.

It's also worth noting that if you leave your job or are let go, you will have to pay your 401(k) loan back within a few months. Otherwise, it's considered a distribution, which triggers income taxes and possibly an additional 10% tax penalty on the loan balance, Golladay says.

That's why it's important that you have a solid plan in place for paying it back in a timely way, Golladay says. Although borrowers are allowed five years to pay back 401(k) loans, doing so in three years or less is ideal, she says.

"By writing down a financial plan — preferably with the help of a knowledgeable professional — you can account and prepare for potential challenges with the goal of setting yourself up for stability in the short term and comfort in retirement," Golladay says.

At the end of the day, pulling funds from your 401(k) early derails your savings efforts for retirement. The pre-tax money 401(k) participants contribute is intended to grow over the course of their careers, Golladay says. By taking a loan, you miss out on tax-deferred growth in the form of investment returns on that part of your savings until the funds are repaid.

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