Pros and Cons of Borrowing from a 401k

The Benefits and Risks of Taking a Retirement Plan Loan

Nov 13, 2009 James Hutchinson

Borrowing from a retirement plan provides cash for current needs, but may reduce the money available later. It is important to consider options carefully.

401K plans are employer sponsored savings vehicles that allow employees to save money for retirement tax-deferred. Taxes are not deducted on money set aside for the 401(k), but the employee is liable for taxes when the money is drawn from the account.

The main benefit the marginal tax rate on income is assumed to be higher when the employee is working and lower after retirement. This is only an assumption and individual circumstances may vary.

Many 401(k)s have provisions that allow employees to borrow against savings. There are specific rules established by the Internal Revenue Service regarding loans from a 401(k). Loans are for a period of five years or less, unless used for the purchase of a primary residence, and then the term may be up to ten years. If the loan is not paid back in full, the unpaid balance is considered a distribution.

Current rules say if there is a distribution to an employee who is less than 59 ½ years old, the amount of the distribution is taxable and that there is a 10% penalty assessed on the gross value of the distribution.

Negatives of a 401(k) Loan

Money deposited in a 401(k) has been set aside for retirement. If the money is borrowed, it will not be earning income, and the less that it earns the less money that will be available when the employee does stop working.

If a person leaves employment with the company sponsoring the plan, the loan may be due immediately. If the job loss is unexpected, paying back the loan may be even more difficult. If not paid back, it will be subject to distribution penalties as above.

Positives of a Employer Sponsored Plan Loan

Many financial planners discourage borrowing against a 401(k), but there are benefits in some cases:

• Interest rates are generally lower than market rates, and almost always lower than credit cards. If the money is used to pay off higher rates, there will be a short term savings. Getting one's financial house in order in the present may be a greater benefit than a larger nest egg to be used in the far future.
• Loans from retirement accounts are not reported to the credit bureaus, and will not effect a person’s credit score, and the repayment amounts are not included as debt when qualifying for other loans such as a mortgage.
• Using the loan for a down payment for a home may allow the consumer to buy rather than rent, allowing for tax savings on interest and the potential to build equity.

Making the Decision to Borrow from a 401(k)

Employees should review options carefully before borrowing from retirement accounts. A solid repayment plan is important; otherwise the retirement account becomes just another vehicle to borrow from to fund current living expenses.

Although maybe not a last resort, taking a loan from a 401(k) should not take the place of a regular savings plan and living within one’s means.

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