The Pitfalls of a 401(k) Loan

EDITOR'S NOTE: This article was originally published in the September 2008 issue of Kiplinger's Retirement Report. To subscribe, click here.

In these trying economic times, you may be tempted to tap your employer-sponsored 401(k) plan. Two words of advice: Think twice.

Before dipping into your 401(k), you will need to understand the possible implications. You could face taxes and penalties, as well as the loss of compounded growth of your retirement savings.

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Rules vary by employer, but most individuals can gain access to their 401(k)s by taking either a loan or a "hardship withdrawal." About 88% of plans in 2006 allowed participants to take loans, according to the Profit Sharing/401(k) Council of America. Under IRS rules, the loan amount generally must be the lesser of $50,000 or 50% of the account balance.

Nearly 20% of participants had a loan outstanding in 2006, according to the Employee Benefit Research Institute. The Vanguard Group reported a 9% increase in hardship withdrawals from 2006 to 2007. "In an economic downturn, it should not be surprising that people are using these features," says Stephen Utkus, principal with the Vanguard Center for Retirement Research.

Repay the Loan -- Or Else

But borrowing rules are strict, so make sure you'll be able to meet the terms. Borrowers have five years to repay the loan. Most employers deduct monthly loan payments, with interest, from your paycheck. If you lose or switch jobs, the loan must be repaid usually within 60 to 90 days. "If you think you'll change jobs or retire, think carefully about taking a loan," says Utkus.

The IRS will count the loan as a taxable distribution if you don't pay it back on time. You will owe income taxes, plus a 10% federal income-tax penalty if you're younger than 59 1/2, on the unpaid balance.

Donna Martinez of Santa Fe, N.M., found herself in that situation. She borrowed $25,000 from her 401(k) five years ago while working for a car dealership. "I was a single parent raising three children," says Martinez, now 51. "I wasn't getting financial support for any of them." She left the company in 2004 for a similar job at another car dealership and continued her monthly $488 loan payments.

Several months later, the firm that ran her former employer's 401(k) plan told her she had to repay the $17,218 balance. "They gave me the option to pay it back in a lump sum or take it as a withdrawal," she says. "I didn't have the money, so I took it as a withdrawal." But the cost was steep: She owed $6,000 in taxes and interest.

One of the biggest downsides of a loan is the loss of compounded tax-deferred growth of the money you've borrowed. For instance, if you take a $20,000 loan from a $100,000 balance and the market climbs 20%, you'll only see growth on $80,000, says Michael Doshier, vice-president for marketing of Fidelity Investments' Retirement Services Division.

And if you're tapping savings as the market declines, you could have an even harder time recouping losses. "A down market is the time to buy stocks," says Christian Weller, senior fellow with the Center for American Progress, a think tank. "You're missing out on the bargain-basement prices."

Still, borrowing isn't always the worst move. "It's a much more sensible form of borrowing than a credit card because the interest rate is lower -- 6% versus 18%, for example," Utkus says. "You're paying back the interest to yourself." The rate is usually the prime rate at the time of the loan plus 1% or 2%.

If you really need the money, you're better off with a loan than with a withdrawal. Employers allow hardship withdrawals only for certain purposes, such as medical expenses, funerals or college tuition. You'll have to pay income tax and possibly penalties on the withdrawal. "The withdrawal is going to have a far more lasting effect on retirement savings than a loan," says David John, a senior fellow with the Heritage Foundation, a think tank. "If the money is withdrawn, it's gone."

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