June 10, 2011
Most company 401(k) retirement savings programs allow qualified participants to borrow money from their account. Usually the amount is limited to a maximum of 50% of the account balance, requires timely repayment, and immediate repayment of outstanding loans should you leave your employer. So is borrowing money from your 401(k) retirement account a good idea?

Why these loans are usually a bad idea
In most cases, borrowing money from a 401(k) is a bad idea. Why?
  1. Opportunity cost. Your investments used for a loan from your 401(k) are no longer earning investment income. Instead it is usually earning a lower interest rate paid by you as you repay your loan.
  2. Tax implications. Your repayment of the loan is usually in "after-tax" dollars. If you are in the 25% federal tax bracket you need to pay $1,250 dollars pre-tax for every $1,000 you borrowed BEFORE applying the interest expense.
  3. Cash Flow. Often those taking out a loan are cash strapped. This loan too, must be repaid within 5 years unless used to buy a home. Have you done the math to ensure you will have cash available to make these new loan payments each month?
  4. Tax penalty. If you do not pay the loan back, you will often be subject to two more tax events. The first is income tax on the unpaid 401(k) loan amount as it is now deemed to be ordinary income. The second is a possible 10% tax penalty for unqualified early withdrawal. In other words, if you miss a payment or two, the tax implications could be huge. In addition, you will be disqualified from the saver's tax credit for 2 years.
  5. Immediate repayment. If you leave your employer, these loans are often immediately due in full within 60 days of leaving your employer. So if you lose your job or wish to change your job you need to be prepared to repay any 401(k) loan balances immediately.

401(k) Loans have Congressional Attention
The increase in use of 401(k) loans and defaults on these loans has captured the attention of our legislators. There is a new bill introduced in the Senate this year called the "SEAL 401(k) Savings Act". If passed the act would:
  • Limit the number of 401(k) loans a person may take from their plan
  • Extend the period of loan repayment to reduce defaults Extend the grace period to repay loans should employment be terminated
  • Ban the use of Debit Cards to access 401(k) balances
  • Allow continued participation in 401(k) programs if locked out of the program due to hardship withdrawals.

While it is usually not advisable to take out a loan from your 401(k) program, sometimes your situation may merit this action. Please make sure you are taking this action with knowledge of the potential risks.

Topic: Advice