401(k) Rules for Borrowers

Borrowing from a 401(k) plan might seem like an easy way to access money for important short-term goals, but it could have significant negative effects on your ability to achieve and maintain long-term financial security. Before you convince yourself that borrowing is the best way to address your current financial priorities, make sure you understand the 401(k) rules and the risks that may apply to you.

The first thing to do if you're considering borrowing from your 401(k) is to find out if your plan allows you to do so. Even though the IRS allows 401(k) loans, it does not require retirement plans to make them available to participants. In some cases, you may not be able to access your 401(k) money unless you are retiring, leaving the company where you work or facing an extreme financial hardship, such as a home foreclosure.

Benefits of borrowing from your 401(k)
With the exception of matching contributions from your employer that have not yet vested, or become yours, the assets in your 401(k) plan belong to you. As a result, many people see no reason to leave that money untouched if they need to address important financial priorities prior to retirement, such as getting out of debt, buying a home or paying for a college education. Typically you can borrow 50% of your vested balance up to a limit of $50,000.

Because you're borrowing from yourself, you repay the principal and interest to yourself, not to a bank or other financial institution. You won't face a credit check, so you're guaranteed to get the loan. Depending on how you use the money you borrow, it could potentially produce better returns than the investments available within your 401(k).

Risks of borrowing from your 401(k)
The most obvious risk of borrowing from a 401(k) is the risk of reducing the amount of money that will be available to help you pay bills during retirement. After all, the money you remove from your 401(k) to spend now will lose the ability to generate any investment earnings in the future, until you've paid it back.

This leads to the risk of opportunity cost, or the chance that your money won't be in your 401(k) when your investments rise in value. Because your retirement plan assets compound annually, the opportunity cost can be very significant over time.

You'll also lose out on tax advantages. The loan isn't tax-deductible, and you'll be paying yourself back with taxable income instead of the pretax contributions you originally made. Fail to pay back the loan in its entirety, and the entire value of the loan becomes taxable as income. If you're under 59 ½ years old, you'll also face a 10% IRS penalty for an early withdrawal.

From a logistical point of view, borrowing from your 401(k) could also pose problems. For example, you may need to pay fees, file complicated paperwork on deadline and wait a significant amount of time before finally receiving your money. In other words, if you need money next week, borrowing from your 401(k) is probably not going to be an effective strategy.

Who should borrow from a 401(k)?
In general, financial advisors will tell you that borrowing from a 401(k) is a last resort. You've set this money aside for your retirement, and that's where it should stay. Even if you pay the loan back, you'll have lost out on potential growth and compounding while the loan was in effect.

If you need money to save your home from foreclosure or to pay unexpected medical bills, borrowing from your 401(k) may be your only choice. Depending on your asset mix, you can minimize the opportunity cost by paying the loan back at an interest rate that is equal to or higher than the historic interest rate for your plan. For example, if you're heavily invested in bonds that produce annual growth of 5%, you'll minimize the damage by paying an interest rate of 7% or 8%.

You can also borrow from your 401(k) to buy assets that are likely to appreciate in value, such as a vacation home or rental property. Don't borrow to cover everyday living expenses, to buy depreciable items, such as cars and boats, or to pay for short-lived splurges like big-screen TVs or cruises.

You also shouldn't borrow from a 401(k) to pay off credit-card debts or loans. Most 401(k) plans are shielded from creditors if you declare bankruptcy, so creditors can't touch them. This will let you weather a current financial storm knowing that you still have savings for retirement.

Borrowing alternatives
Considering the potential risks and inconveniences associated with borrowing from your 401(k), it's often a better idea to pursue alternative strategies for getting money. If you own your home, consider a home equity loan. The IRS will allow you to deduct interest-but not principal-on these loans from your taxes. If you're really in a financial jam, you may want to consider selling your home and using the proceeds to buy a more affordable home and pay off other bills.

Other strategies to consider instead of borrowing from your 401(k) include:

• Being a better budgeter. Many people facing a financial crisis have an eye-opening experience when they take a closer look at their spending habits and priorities. Quite often, they discover that their problems stem from irresponsible spending decisions, not a lack of sufficient income.
• Temporarily reducing 401(k) contributions. Instead of borrowing from your 401(k), you might be able to address your financial challenges by simply reducing the amount of money you set aside in your retirement account each payday. After you've used that extra money to help address your short-term goals, you can increase your contribution rate again.
• Using windfalls wisely. It may be tempting to spend an unexpected influx of cash on something fun, such as a vacation or digital television. But that may prove to be a short-sighted strategy. Make prudent choices about how to spend an unexpected tax return, workplace bonus, inheritance, etc.