Borrowing From Your 401(k)? 6 Traps to Avoid

Photo (cc) by Tax Credits

Faced with a financial emergency and thinking about borrowing funds from your 401(k) to fill the gap? You’re not alone.

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

Regardless 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 401(k) 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 401(k), that money won’t get the benefit of compounding interest.

Says U.S. News & World Report:

The cash you borrow from your 401(k) 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 401(k) 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 401(k). (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 401(k) 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 401(k):

  • 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 401(k), 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.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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