Should You Borrow from Your 401(k)?

You may be tempted to take a loan from your employer sponsored retirement account.  Payments will be deducted automatically from your pay check and you have five years to repay (longer if the proceeds will be used for a down payment on a first-time home).  The interest rate may be low (often, one or two percent above the prime rate) and the paperwork is minimal.  Not so fast.... you need to understand the ramifications of what you are about to do.

My blog posting of 12/29/11, titled “How is Your 401(k) Doing?” advised against borrowing from your 401(k) even if your plan makes loans easy to get.  The posting also advised treating your 401(k) as one of your prized possessions.  Your 401(k) plan may be the deciding factor in determining when you can retire and how comfortable your retirement will be.  It is not wise to borrow from your future to pay for current obligations.

Some of the downsides of borrowing from your retirement account are:

·       The outstanding loan must be repaid within 60 days should you or your employer terminate your employment.  If not repaid the loan will be treated as a taxable distribution and subject to a 10 percent tax penalty if you are under age 59 ½.

·       You will need to have other funds to pay the taxes due which will be payable by April 15 of the year following the year of distribution.  Using retirement funds to pay the taxes will increase the 10 percent penalty.

·       There are lost opportunity costs while the loan is in force as you may be prohibited from making contributions to the plan during this time.  Your interest payments on the loan will be credited to your account, but that may be less than the investment returns you would have otherwise received.

·       Payments on the loan will be deducted from your pay each month, and you generally cannot stop this even if you should incur a financial hardship.

I advise people to take 401(k) loans only as a last resort.  A 401(k) should not be used as an emergency fund or paying for a luxury item or a vacation, nor should it be used if funds are available from other sources.  If you have a true emergency and there are no other funds available, you may have no other choice.  Should this be the case, pay down the 401(k) loan as soon as possible rather than extending for five years.  Five years is a long time, and you may change jobs or be laid off and faced with having to pay off the loan, or have to pay taxes and a 10 percent penalty on the unpaid amount.

Remember you can borrow for many reasons, but your retirement is not one of them.