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Borrowing from Your 401(k) Plan

by Jordan E. Goodman

Of the many options you have when you need to borrow money to make a major purchase, borrowing against your 401(k) is one of the more tempting. There are currently hundreds of billions in dollars of loans against 401 k balances.

Usually you can borrow up to $50,000 or 50% of your 401(k) balance, whichever is smaller. But it shouldn't always be the first place to go when you need a quick and cheap loan.
Here are the pros and cons of borrowing against your 401(k):

Advantages

You can get the loan quickly, usually within a week or so of applying to your company.

You don't have to qualify for the loan through a credit approval process because, after all, you're borrowing your own money.

The interest rate is quite low, usually at prime rate or slightly over prime, so you would pay about 5% - 6% today.

The interest that you do pay is actually paid back to you and your account.
You generally have 5 years to pay it back and usually 10 years if you use it for the down payment on a house.

You avoid any 10% early withdrawal penalties and income taxes that would hit you if you took money out of the 401(k)

Disadvantages

You are slowing down the growth of your retirement fund. The money you withdraw stops growing until you pay it back. Some plans don't allow you to make more contributions if you have an outstanding loan, which hurts your retirement savings even more.

You repay the loan through payroll deduction, so the loan will cut down your take-home pay.

If you leave your job either voluntarily or involuntarily, you have to repay the entire outstanding balance in 60 days or face a huge tax bill. This can be very difficult to do when you are leaving your job, particularly if you are laid off. If you don't pay it back, the remaining balance is hit with a 10% early withdrawal penalty and you have to pay federal and state income taxes on it that year. So if you had borrowed $50,000 and couldn't pay it back, you would have to pay a $5,000 penalty and federal and state taxes that could take another $20,000 of the amount.

Bottom Line

Borrowing against your 401(k) can make sense as last resort if you need to make a major purchase like a house down payment that you can't come up with from anywhere else. But consider this step very carefully before you take it.

Jordan E. Goodman is America's Money Answers Man. He is a regular contributor to Public Radio International's The Marketplace Morning Report and appears frequently on NBC's The Today Show, PBS, MSNBC, CNN, CNBC, and Nightline. For 18 years, Mr. Goodman was on the editorial staff of Money magazine, where he served as Wall Street correspondent, in addition to his role as weekly financial analyst on NBC News at Sunrise for 9 years.

He is the author of Everyone's Money Book (over 200,000 copies sold) with 6 special focus editions on College, Credit, Financial Planning, Real Estate, Retirement Planning and Stocks, Bonds and Mutual Funds and the co-author of Barron's Dictionary of Finance and Investment Terms.
His website MoneyAnswers.com is full of resources, tips and strategies you can use to build a solid financial future.