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Overview

Resist the lure of a 401(k) loan

It's easy to borrow from your plan, but the results can be devastating to your nest egg

Last reviewed: May 2011

Raiding your retirement fund to pay for current expenses is a Money 101 no-no. There are many reasons not to do it, but they mostly boil down to imperiling your retirement savings and incurring potential tax consequences. Yet 2011 data from Fidelity, one of the largest 401(k) managers in the country, showed 22 percent of its clients had outstanding 401(k) loans. An additional 2 percent had taken 401(k) hardship withdrawals, and 27 percent of the people who left their jobs cashed out their retirement-plan balances.

Though some small businesses don't allow employees to borrow from their 401(k)s, many employers make it almost too easy. Typically, you can borrow 50 percent of your account balance up to $50,000, with a repayment term of five years.

Some pros, many cons

Often you don't need approval; a simple statement giving the reason for the loan suffices, and the money is available almost immediately. You might have to pay a processing fee of $75 to $100 to set up the loan. And you'll pay interest on the loan—typically the prime rate, which is currently 3.25 percent, plus an additional 1 or 2 percentage points. So at 4.25 to 5.25 percent, a 401(k) loan will cost you less in interest than almost any other way of borrowing. Moreover, the interest you pay is credited to your account. The repayments can be deducted from your paycheck. No wonder it seems like a good idea to many people.

Now for the downsides, and there are many, which is why we—and many financial advisers—generally don't recommend 401(k) loans. For one thing, you might be creating a bad habit. "Mentally, once you start borrowing from retirement, it's easier to do it again," says John Deyeso, a certified financial planner and analyst in New York. "The point of putting money away for retirement is for retirement."

When you take some of that retirement money out of the 401(k), you'll pay an "opportunity cost"—the loss of the potential earnings that money could have been earning on a tax-deferred basis. If you have an outstanding loan during a bull market, you'll never realize those gains, which could leave you with much less money to spend in retirement.

Moreover, some employers won't pay matching funds to your account or allow you to make additional contributions until the loan is paid. And even if the company does allow you to contribute, you might find it tough to maintain your funding level while you're making loan payments.

To get a sense of how much a 401(k) loan will actually cost you, try this online calculator from Bankrate.com, at bankrate.com/calculators/retirement/borrow-from-401k-calculator.aspx. We used it to see the total cost of a $20,000 loan for someone who is 10 years away from retirement. We assumed a 6 percent rate of return for the account, an interest rate of 5.25 percent on the loan, and a five-year payback period. If the loan was repaid on time, it would cost the borrower $10,035.

If you can't pay back the money within five years, or you leave your job for any reason, you'll typically have to pay the loan back in 60 to 90 days or the balance will be considered a distribution and subject to income taxes. If you're younger than 59½, you'll also pay a 10 percent early withdrawal penalty, though if you're over 55 and laid off, the penalty won't apply. Using the $20,000 loan example above, if the borrower was unable to repay it, the total loss would amount to almost $62,400 including taxes and a 10 percent penalty.

One point to keep in mind if you're in financial straits: The money held in a 401(k) plan is protected from creditors. Once you take it out through a loan, it is no longer protected. And if you use the loan to pay off debt, then file for bankruptcy, you've essentially wasted that money. The bankruptcy court might allow you to restructure or lower the debt, or put you on a payment plan, while retaining your 401(k) balance.

When it might make sense

There are limited circumstances when a 401(k) loan might be a good option. The ideal candidate has a large 401(k) balance, a secure income, and the ability to make the loan payments along with current expenses. One example might be if you had unexpected medical costs that weren't covered by health insurance.

Some people tap their 401(k)s to buy a home. For a first home purchase, some 401(k) plans extend the repayment period to 10 years. And a low-rate 401(k) loan might be preferable to a bridge loan if you buy a new home before you've sold your existing one, says Jeff Feldman, a certified financial planner in Pittsford, N.Y. You can repay the loan after the home is sold.

In divorce situations, often one or both parties need money for immediate expenses. If the withdrawal is handled properly, the couple can avoid the 10 percent early withdrawal penalty, says Bob Burger, a certified financial planner in Phoenix. Burger says he otherwise "cringes" at the notion of recommending a 401(k) loan, but in a divorce it might be necessary. "In many cases, I find it better to liquidate high joint debt with the 401(k) proceeds and then let both spouses move forward with their lives," he says.

Some financial advisers counsel clients with a large amount of high-interest debt to take out a 401(k) loan to pay it off. But you shouldn't follow this advice unless you're certain you won't rack up more debt. "It doesn't do any good to pay if off with a 401(k) loan if you are not willing to change your habits that got you into the mess in the first place," says George Middleton, a financial adviser and accountant in Vancouver, Wash.

Loans vs. hardship withdrawals

In most cases, a 401(k) loan is preferable to a hardship withdrawal. The Internal Revenue Service allows hardship withdrawals from 401(k) plans in some situations, such as to pay tuition or medical and funeral expenses, or to purchase a principal residence, repair damage to a home, or avoid a foreclosure. Employers aren't required to allow such withdrawals, nor do they have to grant them for all of the IRS-approved reasons.

But don't expect the IRS to show any mercy. Like all distributions from tax-deferred retirement plans, hardship withdrawals are taxed as regular income, plus there's a 10 percent penalty if you are under 59½. And you can't make regular contributions to the plan for six months afterward.

If you have a Roth IRA, taking a withdrawal of your contributions—but not your earnings—is preferable to either a 401(k) loan or a hardship withdrawal. Since Roth IRAs are funded with after-tax contributions, you won't owe taxes or face penalties when you take such distributions, according to CCH, a provider of tax information.

This article appeared in Consumer Reports Money Adviser.

Posted: May 2011 — Consumer Reports Money Adviser issue: May 2011