Borrowing From 401(k) Can Lead to Trouble

Some 401(k) participants have found an easy source of credit: They're borrowing from their own accounts.

But be careful. Although most plans offer loans of up to half of your vested balance (with a $50,000 limit), these deals might not be as sweet as they seem.

Plan loans usually charge the prime rate plus one or two percentage points. Because the interest you pay goes right back into your 401(k) account, some employees think the money is in effect free. Not so. In fact, it could cost you more than the stated rate. Say you borrow money from your 401(k) at 3% interest, but the money you pulled out of the account had been earning 8% in a stock fund. That 8% is the real cost of your loan. And remember, you also lose all future compounding on the lost earnings.

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Another potential problem: If you quit your job or are laid off or fired, your loan may be due immediately -- at a time when you may least be able to afford to pay it back. If you can't pay it back, the outstanding balance will be considered a taxable distribution and, if you are under 55, you will get hit with a 10% early-withdrawal penalty as well.

Plan loans generally must be repaid within five years. But if you use the money to buy a home, you can stretch out repayment over a longer period. If you use a plan loan to buy a house, ask whether you can secure the loan with your house. That way the interest would be tax-deductible.