Borrowing From Your 401(k) Could Be Hazardous To Your Wealth

Borrowing from your 401(k) plan should be your last resort, not your first. Ideally, you will never touch your retirement funds, allowing them to grow continuously until you retire. But we don't live in an ideal world! With home prices falling and lenders tightening credit, an increasing number of Americans are borrowing money from their 401(k) retirement plans. In the long run, the disadvantages clearly outweigh the advantages.

Taking loans against a 401(k) plan is allowed by law, but an employer is not required by law to allow it. If offered, an employer must adhere to some very strict and detailed guidelines on making and administering a loan. The statutes governing plan loans place no restrictions on what the need or use will be for loans, but an employer can restrict the reasons for loans. Some plans charge fees when you borrow from your 401(k). Plans can charge a one-time fee, a maintenance fee, or a combination or the two.

There are several advantages to a 401(k) loan over other types of loans. A plan participant can borrow up to half of their vested balance, but no more than $50,000. There is no credit check and no qualifying, although you may need a spouse to sign a consent form. You may receive the loan in a matter of days and have up to five years to pay the money back, except when the funds are borrowed for the purchase of a residence, in which case you may have up to 15 years.

You pay interest on the amount borrowed - often the "prime rate" plus one or two percentage points. Interest proceeds then become part of the borrower's plan balance. There is a popular misconception that paying back a plan loan is like paying yourself. While it is true that you are paying yourself interest, when you borrow money from yourself you are simply replacing the interest you would already be receiving from someone else with interest payments from yourself. Paying yourself interest is sound advice when it is an alternative to paying someone else interest, but not as an alternative to receiving interest from someone else.

You repay the loan through automatic payroll deduction with after-tax dollars, plus you lose the compounded interest that you would have received if you had left the money alone because the amount that you borrow is subtracted from the principal balance. You have no flexibility in changing the payment terms of your loan. You also get taxed twice - once when repaying the loan with after-tax dollars, and a second time when the money is withdrawn at retirement.

So, let's say your monthly payment is $300 and you're in a 28% Federal tax bracket. You'll have to make $416 in gross earnings to have enough left after taxes to make the $300 payment. Interest paid on the 401(k) loan is not tax-deductible even if you borrowed the money to purchase a residence.

If you default on a 401(k) loan, you will receive a Form 1099 from the plan because the government considers the defaulted balance a taxable withdrawal. You will be charged Federal and State taxes on the outstanding balance plus a 10% penalty if you are under 59 1/2 years of age.

The biggest disadvantage is the following: If you leave your job, even if it is not your choice to leave, the 401(k) loan comes due and typically must be repaid within 30 to 90 days. If you cannot pay the loan in full you will be charged Federal and State taxes on the outstanding balance plus a 10% penalty if you are under 59 1/2 years of age.

Another disadvantage is the temptation to reduce or eliminate the amount you are contributing to the plan because you now have a loan payment, which will reduce your long term retirement account balance. If you stop contributing while you have an outstanding 401(k) loan, you will also miss out on the company match, provided your company offers a match.

Lastly, when you apply for a mortgage, current lending guidelines state that any 401(k)loan payments will be counted as a debt and included in your debt ratios and any outstanding loans will be subtracted from the your vested 401(k) account value for reserve purposes.

The bottom-line is if you are considering borrowing from your 401(k) make sure you understand the consequences, both good and bad.