More Cons Than Pros To 401(k) Loan

In the past year, the credit crunch has spread from mortgages to student loans and other types of debt. Home equity lines of credit have been reeled in.

Still, there is one place where you can generally easily get a loan. It's your 401(k) account.

About 90% of 401(k) plans let members borrow their own money, according to consulting firm Watson Wyatt. Small-company plans are less likely to allow borrowing. In plans that do allow loans, borrowers can usually take out up to 50% of their vested account balance. The cap is $50,000.

A slowing economy and increased home foreclosures have fueled more demand for 401(k) loans.

"Nearly 20% of companies across the country reported increases in loans and hardship withdrawals from their 401(k) accounts in a recent quarter," said Anne Lester, a managing director at JPMorgan Asset Management.

These loans have several advantages. But not everyone is a fan.

"You're better off trying to borrow from a relative, even one who doesn't like you," said Ed Slott, an accountant specializing in retirement planning, in Rockville Centre, N.Y.

If you are considering a 401(k) loan, you should know the pros and cons. What are the advantages?

The paperwork is simple. At some companies, loans are available upon request.

Others may have a short application to fill out. But you won't have to hassle with all the forms you're likely to encounter at a bank.

You'll probably get your money faster than you would if you applied for a loan from a third party.

There's no credit check. You don't have to demonstrate your ability to repay the loan.

You're repaying yourself. The interest you pay goes to your own 401(k) account, not to a lender.

Some 401(k) plans set the interest on loans at the prime rate plus 1%. The prime is now 5%. So you might pay 6% interest on your loan.

You might consider that a reasonable return, within your 401(k).

But there are potential drawbacks to loans. One of the biggest is that a loan will likely reduce the amount you save for retirement.

Fiscal Fallout

Suppose a hypothetical Alice Anderson has $200,000 in her 401(k). She needs $50,000 for a home renovation.

She takes it from a bond fund, paying 4.5% interest, in her account. She must repay the loan over five years. That's usually the maximum repayment period allowed by law.

Repayment will come out of Anderson's subsequent paychecks. That's a common practice. Repayments are typically the same amount each period. They are amortized like any consumer loan. Early payments are mostly interest.

So 401(k) borrowers such as Anderson might be left with less take-home pay.

"If they are getting less pay, many people will cut back on their current 401(k) contributions," Slott said.

That can reduce the size of your nest egg by retirement. And if you borrow from stock funds, you could permanently lose out on investments that grow faster than the interest you pay on the loan. Again, it can cut the amount of money you eventually have for retirement.

There's another hefty cost built in to a loan. You repay it with after-tax dollars. And once you retire, you'll face normal income tax on the amounts you withdraw.

So you'll wind up paying tax twice on some income, Slott says.

And this might be a bad time to borrow from your 401(k). "Participants borrowing during the current market downturn are selling assets at depressed values," Lester said.

As you replace those shares in your account, the market may rally. You're likely to pay more for them. Meanwhile, you will have lost time. You'll have less opportunity for growth when stocks turn up again.

In a best-case scenario, a good time to borrow would be at the top of the market. You'd be turning soon-to-depreciate assets into debt that could be put to work on home improvements or other projects. Of course, timing is crucial. Get that wrong, and this advantage evaporates.

The currently wobbly economy poses another risk. You could be laid off. Many firms require former employees to repay 401(k) loans in full within 60 days of leaving. That might not be possible if you took the loan because you were short of cash.

If you don't repay the loan on time, unpaid amounts will be treated as taxable distributions. And you might owe a 10% early withdrawal penalty if you're younger than 591/2. You risk incurring other penalties as well.

Court Contest

One taxpayer fought the IRS' imposition of taxes and penalties after a default on a 401(k) loan. The IRS won in a recent Tax Court decision.

Counting taxes, interest and penalties, the taxpayer's retirement account was wiped out, Slott says.

The bottom line is that a 401(k) loan should be a last resort, Lester says. It can be a source for money that's desperately needed if you have no other source of funds.

But borrowing from your 401(k) to enhance your current lifestyle is probably a bad idea.

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More Cons Than Pros To 401(k) Loan