Should you borrow from your 401(k)?

Investing tip of the month from Morningstar Investment Research Center, by Christopher Davis, Mutual Fund Analyst

The Basics
Whether you can take a loan out on your 401(k) depends on if your employer has decided to give you the option. If borrowing is an option, you'll usually be allowed to borrow up to 50% of your account balance, up to $50,000. You'll have to pay interest on your loan, typically a percentage point or two above the prime rate, and generally speaking, you'll have five years to pay it back. (If you've taken a loan to buy a house, you'll probably have 10 years.) You start repaying right away, with equal payments over the term of your loan that are taken directly out of your paycheck.

The Case for Borrowing from Your 401(k)
So you've got a financial emergency on your hands, and you need some quick cash. A 401(k) loan looks like a better option than the alternatives. Sure, you've got to pay interest on your 401(k) loan, but it's actually credited to your account. Unlike other loans, you're paying interest to yourself and not lining the pockets of a bank or credit card company.

And taking a loan is certainly preferable to taking money out of your account outright. Employers may give 401(k) plan participants the option to do so in the event of financial hardship, which the federal government defines as payments for an un-reimbursed medical expense, purchasing or repairing of a primary residence, college expenses, rent or mortgage payments to prevent eviction or foreclosure, and funeral expenses. Unlike in a loan, permanent withdrawals trigger a 10% penalty, in addition to taxes you'll have to pay on the withdrawal amount.

Why You Should Avoid 401(k) Loans
Borrowing from your 401(k) will likely make it harder for you to meet your financial goals. Because you're taking money out of the market, you'll miss out on the gains you would have benefited from otherwise. It would be a mistake to call repaid interest a "gain." Because borrowers pay themselves interest, they're merely shifting money from one pocket to another.
It also may be more difficult to maintain your current contribution rate when you've got to pay back your loan at the same time. If you end up cutting back, you'll end up retiring with a smaller account. And keep in mind that relatively small amounts really add up over time. Let's say you contribute $1,000 less to your 401(k) this year. If stocks average a 10% annual return, that $1,000 would have turned into $17,450 over the next 30 years.

Moreover, you could run into some serious trouble if you lose your job or change employers. That's exactly what happened to a friend of mine, who borrowed from her 401(k) account to put a down payment on a house. Soon after, she lost her job. Her plan, like many others, required her to pay back her loan in full within 60 days of leaving her company. Out of work and now with a mortgage to pay, she couldn't handle the full balance. As a result, she defaulted on her 401(k) loan, meaning she had to pay taxes on her loan balance on top of the 10% penalty for early withdrawal.

Had my friend kept her job, her decision to borrow from her 401(k) might've looked better. If the value of her new home rose more quickly than the stock market and more than made up for the costs of borrowing, then she'd appear pretty smart. But the problem is that there's no way of guaranteeing that would happen. In the end, she's using her retirement savings to speculate on real estate prices. The recent slowdown in home prices is one reminder why that's not a good idea.

Your Retirement Plan Is for Retirement
With corporate pensions fading away and the future financial health of social security dicey, most of us will heavily rely upon our 401(k) when we retire. If you start thinking of your 401(k) as a piggy bank you can raid whenever you need money, you risk jeopardizing your prospects for a secure retirement.

Admittedly, most people probably aren't borrowing from their 401(k) for the wrong reasons. They're often trying to do the right thing, getting rid of credit card debt or meeting other real financial needs. But your 401(k) should be absolutely the last thing you should touch. If you want to pay off your credit cards, take a hard look at your expenses and see where you can cut back. And to deal with life's inevitable financial surprises, start building an emergency fund that you can draw upon when you need it. If you have to borrow, some financial planners suggest taking a home equity loan instead of tapping into your 401(k). At least the interest from your loan is tax deductible.

In short, borrowing from your 401(k) is one last resort you don't want to check into. For more about 401(k) plans, download the Retirement Planning primer from Morningstar Investment Research Center's Help and Education area.

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