How To Take Out A 401(k) Loan-And Why You Shouldn’t

If you want to take out a 401(k) loan to pay for unexpected expenses, you need to know the risk---and there are a lot of them.

As the economy hiccups, more workers are turning to 401(k) loans for emergency cash. According to the Center for Retirement Research at Boston College, 11 percent of plan participants borrow from their 401(k) plan each year.

The temptations to take a 401(k) loan are plenty: to make a down payment on a home, to pay down high interest credit card debt, or as an alternative to traditional loans amidst a tighter lending market. While taking a loan from your 401(k) account is not difficult, it’s NOT a good idea. Keep reading to find out why.

What’s Ahead:

So, what is a 401(k) loan?

A 401(k) loan is a lump-sum disbursement from funds that you have saved in your retirement account. You must repay the loan over a fixed-amount of time—with interest—back into your 401(k) account.

You can borrow between sixty and eighty percent of your 401(k) balance, and occasionally up to the full account value. The loan is set-up through your 401(k) plan administrator.

In some ways, a 401(k) loan seems like a good idea. Essentially, you borrow money from yourself, so interest charges go right back into your retirement account instead of to the bank. And, since it’s secured by your own money, there is no credit check to take a loan, and you can’t default and find creditors knocking down your door.

Why 401(k) loans are bad

Despite these apparent benefits, 401(k) loans are a bad idea for two reasons.

No more earned interest

When you borrow money from your 401(k), those funds stop earning compound interest until they are repaid. Even if your 401(k) balance is small, a couple hundred dollars in interest over a few years could turn into many thousands over 30 years.

Even more important, contributions (including loan repayments) to your 401(k) are dependent on you being eligible to receive that benefit from your current employer. If, for any reason, you leave your employer, the entire balance of your 401(k) loan becomes due.

Serious penalties if you can’t pay

Can’t pay up? The remaining loan balance will be treated as a pre-mature cash withdrawal from your 401(k), subject to at least a 20 percent federal income tax, state tax, and a 10 percent early withdrawal penalty.

So if you borrowed $10,000, had repaid $2,000, and lose your job—you are freed up from repaying the $8,000 to your retirement account, but you will be hit with a $2,400 federal tax bill.

That’s one expensive loan.