Should You Borrow From Your 401(k)?

Well, now I know how to get your attention. In an article entitled "Avoid these 401(k) Mistakes," I wrote that it is always a bad idea to borrow from your 401(k). Judging by the flood of e-mail messages I received in response, a lot of folks disagree. Most readers offered some interesting insights, but I still think borrowing from your 401(k) is something you should avoid. Why do I think so? Let's first take a look at how 401(k) loans work, their potential advantages, and why they're unwise.

The Basics
Whether you can take a loan from your 401(k) depends on whether your employer has decided to give you the option. If borrowing is an option, you'll usually be allowed to borrow up to 50% of your account balance, up to $50,000. You'll have to pay interest on your loan, typically a percentage point or two above the prime rate, and generally speaking you'll have five years to pay it back. (If you've taken a loan to buy a house, you'll probably have 10 years.) You start repaying right away, with equal payments over the term of your loan that are taken directly out of your paycheck.

The Case for Borrowing from Your 401(k)
So you've got a financial emergency on your hands, and you need some quick cash. A 401(k) loan looks like a better option than the alternatives. Sure, you've got to pay interest on your 401(k) loan, but it's actually credited to your account. Unlike other loans, you're paying interest to yourself and not lining the pockets of a bank or credit card company.

And taking a loan is certainly preferable to taking money out of your account outright. Employers may give 401(k) plan participants the option to do so in the event of financial hardship, which the federal government defines as payments for an unreimbursed medical expense, the purchasing or repairing of a primary residence, college expenses, rent or mortgage payments to prevent eviction or foreclosure, and funeral expenses. Unlike in a loan, permanent withdrawals trigger a 10% penalty, in addition to taxes you'll have to pay on the withdrawal amount.

Why You Should Avoid 401(k) Loans
Borrowing from your 401(k) will likely make it harder for you to meet your financial goals. Because you're taking money out of the market, you'll miss out on the gains you would have benefited from otherwise. A few readers wrote me noting that the interest rate their 401(k) earns from the loan now approaches 10%, which is a competitive rate of return relative to the stock market's historical gains. But it would be a mistake to call that repaid interest a "gain." Because borrowers pay themselves interest, they're merely shifting money from one pocket to another.

It may also be more difficult to maintain your current contribution rate when you've got to pay back your loan at the same time. If you end up cutting back, you'll end up retiring with a smaller account. And keep in mind that relatively small amounts really add up over time. Let's say you contribute $1,000 less to your 401(k) this year. If stocks average a 10% annual return, that $1,000 would have turned into $17,450 over the next 30 years.

Moreover, you could run into some serious trouble if you lose your job or change employers. That's exactly what happened to a friend of mine, who borrowed from her 401(k) account to put a down payment on a house. Soon after, she lost her job. Her plan, like many others, required her to pay back her loan in full within 60 days of leaving her company. Out of work and now with a mortgage to pay, she couldn't handle the full balance. As a result, she defaulted on her 401(k) loan, meaning she had to pay taxes on her loan balance on top of the 10% penalty for early withdrawal.

Had my friend kept her job, her decision to borrow from her 401(k) might have looked better. If the value of her new home rose more quickly than the stock market and more than made up for the costs of borrowing, then she'd appear pretty smart. But the problem is that there's no way of guaranteeing that would happen. In the end, she's using her retirement savings to speculate on real estate prices. The recent slowdown in home prices is one reminder why that's not a good idea.

Your Retirement Plan Is for Retirement
With corporate pensions fading away and the future financial health of social security dicey, most of us will heavily rely upon our 401(k) when we retire. If you start thinking of your 401(k) as a piggy bank you can raid whenever you need money, you risk jeopardizing your prospects for a secure retirement.

Admittedly, most people probably aren't borrowing from their 401(k) for the wrong reasons. They're often trying to do the right thing, getting rid of credit card debt or meeting other real financial needs. But your 401(k) should be absolutely the last thing you should touch. If you want to pay off your credit cards, take a hard look at your expenses and see where you can cut back. And to deal with life's inevitable financial surprises, start building an emergency fund that you can draw upon when you need it. If have to borrow, some financial planners suggest taking a home equity loan instead of tapping into your 401(k). At least the interest from your loan is tax deductible.

In short, borrowing from your 401(k) is one last resort you don't want to check into. For ideas about where to turn if you find yourself in a cash crunch, check out Christine Benz's recent article.

A version of this article appeared on July 3, 2007.