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Borrowing from your 401k? 6 traps to avoid

First among them: You'll likely be damaging your retirement prospects. Leave the money alone if you can.

By MSN Money Partner May 6, 2014 12:42PM

This post comes from Allison Martin at partner site Money Talks News.

Money Talks News on MSN MoneyFaced with a financial emergency and thinking about borrowing funds from your 401k to fill the gap? You're not alone.

According to the Employee Benefit Research Institute (.pdf file), 21 percent of 401k plan participants whose plans allow loans have an outstanding loan balance.

Hands holding a nest with money in it © Tetra images/Getty ImagesRegardless of your unique financial situation, you could be attracted to this option for one of the following reasons:

  • The ability to borrow up to 50 percent of the vested balance, but no more than $50,000.
  • Convenient payback through payroll deduction.
  • It’s a tax-free loan with a repayment period of up to five years.
  • The application process isn't burdensome.
  • No credit check is required.
  • The administrative costs and interest rates (the prime rate plus 1 percent) are low.
  • The loan is exempt from the early-withdrawal penalty.

Sounds pretty good, right? But here are six reasons why borrowing from your 401k should occur only after careful thought -- and only when you desperately need cash and are low on options.

1. Compromising your nest egg

The earlier you start saving for retirement, the more time you give your money to work for you and to recover from market dips. When you take out a loan from your 401k, that money won't get the benefit of compounding interest.

Says U.S. News & World Report:

The cash you borrow from your 401k is generally paid back at a fixed interest rate. It does not earn the market rate that would have been accumulated if the money had been left in the account, which could be higher or lower depending on how the market performs and the investments selected.

It may be tempting to borrow funds to make a down payment on a new vehicle or to pay off debt, but time is a precious commodity for a 401k and any other retirement plan. Once it's gone, you can't get it back.

2. Severe late-payment penalties

Before you take out a loan, it's in your best interest to devise a repayment plan so that you can make timely payments and pay off the debt within the time allowed.

Fall behind by 90 days, or don't have the money to repay the loan within the allotted time? You'll pay income tax on the outstanding balance of the loan, plus a 10 percent penalty if you're younger than 59½.

3. Layoffs or job changes

Parting ways with your employer? Whether it's voluntary or involuntary, you'll generally have 60 days to pay off the entire loan or face tax and penalty on the outstanding balance.

4. Brief repayment period

Usually borrowers have five years to repay money borrowed from a 401k. (Exceptions apply to loans to buy a home and those taken out by active-duty service members.) If you borrowed only a few thousand or less, this is feasible. But what about those who took out much more -- up to $50,000? That can be a short amount of time to repay a large amount and also keep up with other expenses.

5. Administrative fees

Plan administrators pass on the cost of loan maintenance to you in the form of origination and maintenance fees. Though they are usually not much, it's never fun to pay to borrow your own money.

6. Loss of protection from bankruptcy

Your 401k is off-limits to creditors if you file for bankruptcy. That changes for money you've borrowed from your retirement account. Consumer Reports says:

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.

Alternatives to consider

There are other actions you can take to avoid borrowing funds from your 401k:

  • Use your cushion. If you have an emergency fund, now's the time to put it to good use. (If you don't have a cushion, you need to start saving for one.)
  • Work out a repayment plan. If you can't meet your current obligations, contact the creditor.
  • Borrow from family and friends. Proceed with caution because an outstanding loan is not worth ruining a valuable relationship.
  • Take out a personal loan from a bank.
  • Consider a home equity loan or line of credit.
  • Withdraw from a Roth IRA. There's no penalty or taxes for early withdrawal of your contributions. (The rules are different for withdrawal of Roth IRA earnings.) However, you're still shortchanging your retirement funds. Leave the money alone if you can.

If you must tap into your 401k, proceed with caution. The exact terms and conditions can vary by company. You may end up figuring out that borrowing against your nest egg is not worth it after all.

More from Money Talks News

May 8, 2014 2:08AM
with drawing money can be labeled as {stupid is what stupid does) most people that get in that situation will continue to make poor decisions that keep them making the same mistakes all the time dealing with IRA account. most think uncle Sam will bale them out later.
May 10, 2014 5:08PM

As long as you have the means to pay the loan back to your employers 401k, it is a great, short time loan source.  I have taken loans from the 401k program frequently over 29 years of working because it is easy to get, easy to re/prepay and, lets face it, the interest rate on bank money is WAY higher that what you pay for a 401k loan.

In the end, as most Conservatives will tell you, personal accountability for YOUR decisions should be carefully considered.  Democrats don't think you are smart enough to make your own decisions - so they prefer to do that for you at a hefty price.

In the end, we all have to take responsibility for our own choices - politics aside.

May 10, 2014 3:42PM
The article states the interest rate is low, prime plus 1%.  And that you're paying yourself interest.  On the surface this does appear low, but what isn't factored in is the true rate you end up paying in the long run.  You are borrowing money that must be paid back.  The funds used to pay back the loan are after tax funds.  So you're putting after tax funds into a tax-deferred account.  Now when you are eligible to withdraw funds from your 401(k), guess what, you get to pay income tax again.  You've effectively paid double taxes on your loan repayment funds.  So instead of prime plus 1% you've paid double income tax on that loan.
May 10, 2014 11:17AM

MSN assumes everyone is stupid and undisciplined.  Consider this, borrowing small amounts ($5,000 or less) over several months can be very smart since the interest you pay back is paid to yourself, not a bank.  Also, banks usually charge a loan fee (about $100-$200).

Next time do your homework, MSN!

May 10, 2014 10:11AM

Some times people will need to withdraw from a 401k, Most reasons are foolish.

People need to make a plan and adjust because there are bumps on the road of life..

May 10, 2014 2:57PM

I'm retired.  I got a small loan for a scooter ($5K).   Can I borrow $5K from my 401k and pay it back?

I don't get a paycheck anymore, but would do "auto pay" from my checking acc't.  Anybody got an answer?

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