Pros & Cons of Borrowing Against a 401(k)

by Trudy Brunot
Tapping your 401(k) may be an option for financial emergencies.

More than six out of 10 American households use 401(k) plans to save for retirement. This employer-sponsored benefit allows workers to set aside money from their paychecks before income tax withholding is calculated. The Internal Revenue Service taxes contributions and earnings when they're withdrawn and penalizes early withdrawals, with few exceptions. If plan guidelines permit, employees can borrow against their 401(k). Slightly more than one in five eligible participants had an outstanding 401(k) loan at the end of 2010, according to the 2012 Investment Company Fact Book.

Overview

Tapping your 401(k) may be an option for financial emergencies.

More than six out of 10 American households use 401(k) plans to save for retirement. This employer-sponsored benefit allows workers to set aside money from their paychecks before income tax withholding is calculated. The Internal Revenue Service taxes contributions and earnings when they're withdrawn and penalizes early withdrawals, with few exceptions. If plan guidelines permit, employees can borrow against their 401(k). Slightly more than one in five eligible participants had an outstanding 401(k) loan at the end of 2010, according to the 2012 Investment Company Fact Book.

Pros

A 401(k) loan gives you access to cash without credit-score concerns.

The decision to borrow from a 401(k) mirrors that for taking out any loan, said Dr. David E. Littell, co-director of the New York Life Center for Retirement Income at The American College in Bryn Mawr, Pennsylvania. "You must determine the cost and consider the possibility of defaulting on the payments," he said. Interest rates determine a loan's affordability and access, two factors that Littell puts on the plus side of borrowing from your 401(k). "The rates on 401(k) loans usually fall 1 or 2 percent over the prime rate, so they are relatively cheaper than other available loans, and certainly better than credit cards," he said. Participants who might not be eligible for an unsecured consumer loan benefit from the ability to access their retirement savings. "Your credit rating isn't an issue with a participant loan because the account balance serves as security." Borrowing from your 401(k) offers convenience beyond easy access to cash: You're paying interest to yourself and your retirement, not to a lender. Although IRS regulations require loans to be repaid on a regular basis within five years, your plan provider handles the process for you. "401(k) loan payments are almost always made on a salary reduction basis, making repayment easy and the chance of defaulting contingent only on employment termination," noted Littell.

Cons

401(k) loans affect the long-term performance of your retirement savings.

"Borrowing from your 401(k) plan doesn't make financial sense for a number of reasons," said Greg Pinto, Baystate Wealth Management's chief investment officer, based in Boston. "The reason you have a 401(k) in the first place is to save for the future, so you're defeating the purpose if you use the money before you retire." He cites a 2012 Employee Benefit Research Institute survey that reported 86 percent of Americans believe they did not have enough money for a comfortable retirement. "Every dollar you take from your 401(k) is one less you’ll have for your 'golden years'," said Pinto. The temptation to contribute less to make the payments or being banned from contributing until you pay off the loan add to this uphill climb. "It's unlikely you’ll recoup it through future contributions," he added. Lost opportunity to grow your nest egg tops Pinto's list of 401(k) loan negatives. "It's true that you pay a low interest rate, but equity and fixed-income markets generally earn a higher rate of return," he said. That lost opportunity strikes home when your job's eliminated or you change employers: The loan becomes due immediately and if not paid back in full within a short time frame brings with it taxes and a 10 percent early withdrawal penalty. "It becomes a withdrawal as far as the IRS is concerned," said Pinto. He suggests having a budgeting conversation before making your decision. "Taking loans from your 401(k) could indicate you're living beyond your means."

Considerations

When you need money for an emergency, your 401(k) represents a reliable source that doesn't involve credit checks or a lengthy approval process. While removing money from your retirement savings means you lose the opportunity for it to grow during the life of the loan, the interest you pay on your loan goes back into your account tax-free. The biggest risk for plan borrowers relates to continued employment: If you leave or lose your job while the loan is outstanding, you must repay the balance within 60 days to avoid steep penalties and early withdrawal taxes. A decision to borrow against a 401(k) should be made within the context of your total financial picture.

About the Author

Trudy Brunot began writing in 1992. Her work has appeared in "Quarterly," "Pennsylvania Health & You," "Constructor" and the "Tribune-Review" newspaper. Her domestic and international experience includes human resources, advertising, marketing, product and retail management positions. She holds a master's degree in international business administration from the University of South Carolina.

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