Are 401(K) Loans a Good Solution?

According to Bankrate.com, 19% of Americans used their retirement savings last year to cover the cost of an emergency. Most people need to borrow money at some point, but is borrowing from a 401(k) plan the best solution?

Before considering borrowing from a 401(k) plan, it’s a good idea to weigh the benefits against the costs. Also, keep in mind that not all 401(k) plans allow employees to borrow from their accounts. Check with your human resources department before you even start considering a loan.

At first glance, it may seem very attractive to borrow from your 401(k) plan. You can borrow up to 50% of your account value up to a maximum of $50,000. Also, borrowing from a 401k plan is unique in that you are borrowing from yourself rather than from someone else. The interest and principal you pay are returned to your plan.

Here’s a simple example that illustrates what you’re essentially doing by borrowing from your 401(k) plan. Suppose you put ten $10 bills in your right pocket. He then transfers the bills to his left pocket and places an IOU for $100 in his right pocket. Each month you return a $10 bill to your right pocket and use fifty cents from your piggy bank to pay the required interest.

As the example illustrates, the cost of borrowing from a 401(k) can be minimal. However, the individual in our example is not exactly making progress either. The problem is that you are only exchanging your own money. He is missing the opportunity to build his 401(k) from an outside source in the form of new contributions, employer matches, growth, interest, and dividends.

Taking a loan from your 401(k) has other costs. Most plan administrators charge a fee to prepare loan documents. A large servicer in Utah charges $75 to set up an employee loan. Worse yet, some employers won’t allow you to continue contributing to your 401(k) plan until the loan is paid off. So you could forego matching contributions, one of the biggest benefits of an employee retirement plan.

To return the money, you must establish a strict payment schedule. The payback period cannot be longer than five years (except for funds withdrawn to purchase a home), and you will generally make monthly payments using a reasonable interest rate, typically the prime rate plus 1%. Many employers automatically deduct the loan repayment from the employee’s paycheck, with after-tax dollars! Of course, this negates another of the biggest benefits of a 401(k) plan in that you no longer get the tax deferral.

If you leave an employer while you have a loan balance, you have to pay the entire outstanding loan balance. If you default, the IRS will treat the loan as a distribution. You will then be subject to income taxes and, if you are under 59½, you will have to pay a 10% penalty.

Before you borrow from your 401(k), ask yourself why you want to borrow money. Reasons to borrow money range from really important things, like medical bills or buying a house, to things that simply feed our egos, like new cars or exotic vacations. If you’re borrowing to buy something that isn’t essential, you should consider a source other than a 401(k) plan. It is not a good idea to replace valuable assets (your 401(k)) with assets that depreciate.

In general, I believe a 401(k) loan should be considered only if it is essential and all other financial resources have been exhausted. However, there are cases where a 401(k) loan can be a fantastic solution. For example, I have a client who expects to receive an inheritance in the next few months. However, this client would like to purchase a new home immediately and needs funds for a down payment. It makes sense for this client to borrow from their 401(k) plan to cover the initial cost of the home loan and pay off the loan in full once the inheritance is received. This allows this person to borrow funds at a low cost but without losing the great benefits that his retirement plan provides.