Should You Borrow from Your 401(k) Plan?
You've contributed to your 401(k) on a regular basis and watched your account grow. But now you need cash for that home improvement project or long overdue vacation. If you're thinking about taking a loan from your 401(k) or similar retirement plan, you need to consider the true costs of doing so.
HOW IT WORKS
According to a recent survey, almost 82% of participants in 401(k)s are in plans that permit them to borrow from their accounts. While loans may be allowed for any reason, many plans allow them only in specific situations, such as buying a house or paying for college tuition.
Most 401(k) plans allow you to borrow up to half of your account balance, but not more than $50,000. You make a loan to yourself and promise to pay back the balance plus interest at the fixed rate determined by your plan. Payments must be made at least once every quarter and are typically deducted from your paycheck—much the same as your 401(k) contributions. Federal tax law requires that you repay the entire loan within five years, the exception being if you use the money to buy a home, in which case you get up to 25 years (but not beyond your normal retirement date). The interest rate you'll pay is usually competitive, as the Internal Revenue Code requires that you charge yourself a "market rate" for the loan. The market rate is usually 1%—2% over prime and is considered to be the rate you'd pay if borrowing from a bank.
IS THE CONVENIENCE WORTH THE COST?
Borrowing from your 401(k) is much easier than borrowing from a bank because there are no credit standards to meet. Since you own the money in your account, you automatically qualify for the loan. In addition, some borrowers may find other sources of financing to be more expensive, in which case a retirement plan loan can save money in interest paid.
However, the convenience of these loans comes with strings attached. If you leave your employer, voluntarily or involuntarily, you will have to pay the outstanding loan balance within 60 days. Fail to do so and the IRS will treat the loan as an early withdrawal, charging you income taxes and an early withdrawal penalty of 10%. In the case of a job change, you may be able to plan ahead and pay off the loan within 60 days. But in the case of an unexpected job loss, getting the money to repay the loan on such short notice could be very hard, adding the pain of a difficult tax situation to the stress of being newly unemployed.
Even more fundamentally though, are these loans really a good deal? In most cases, they aren't. The reason is simple: when you borrow from yourself, you don't earn a true "return" on your money. The interest you "earn" for your 401(k) has actually come directly out of your regular paycheck. The interest isn't extra money—it's simply money taken from one pocket and put in another. There's more money in your retirement account, but less money in your paycheck. In fact, because the interest you pay is with after-tax dollars, you get the dubious privilege of paying tax on that money twice—once in your paycheck now, and again when it is withdrawn from the plan eventually as ordinary income.
Finally, consider the opportunity cost of the loan. Instead of compounding tax-free in a stock fund, your retirement balance earns the lower rate of a fixed income investment. And as we've seen, even those "earnings" are an illusion. As a result, borrowing from your 401(k) can put a big dent in the final amount you accumulate for retirement.
WHAT TO DO INSTEAD
If you face a situation where borrowing is absolutely necessary, there often are other options available. A few include:
• Home equity loans. If you qualify, a home equity loan can be an excellent alternative. Home equity loans usually make better economic sense anyway because the interest payments are typically tax-deductible.
• Margin loan. If you have a brokerage account, you can borrow from your broker using a "margin loan" arrangement where the holdings in your account serve as your collateral. The interest rate is attractive, generally prime plus 1%. This is also an attractive option because it preserves the tax-free compounding of the money in your retirement plan.
• Life insurance. Money can be borrowed from a whole-life insurance policy. An advantage here is that you're not truly taking on new debt—it's money you have accumulated as a sort of savings in a life insurance product. You're effectively borrowing from yourself, but without some of the nasty side effects of doing so within your retirement plan.
• Have your 401(k) contributions temporarily stopped. Many people forget that they can simply have their new contributions stopped or reduced temporarily. If this will meet your needs, it's probably a better option than borrowing from your current balance.
If you still need to consider a loan from your 401(k), your objective should be to seek a balance between two competing desires—to maximize the return in your retirement plan while minimizing the cost of your borrowing. To do this, you should determine what interest rate would be roughly equal to your projected investment return in your 401(k) over the term of the loan. Since the loan effectively becomes a fixed-rate investment in your 401(k), you should compare the rate you would expect to earn in your plan's bond fund to the rates of interest available via other lending sources. If this interest rate is lower than the loan rates you qualify for elsewhere, a retirement plan loan may be an acceptable choice. Just be careful to weigh all the risks, and if you do proceed, be sure to reallocate your plan holdings to reflect that your loan is now part of your bond allocation.
A loan from your retirement plan isn't always a bad decision. But as we've seen, there are significant drawbacks, so consider all of your options carefully before dipping into your 401(k). Your decision can seriously affect the growth of your retirement savings, or worse. 
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