Yahoo Finance Pros and Cons of Taking a 401(k) Loan
Borrowing from your 401(k) account might sound like a good idea if you need the cash to pay off debt, buy a car, go on vacation or fund a business startup.
After all, if it's vested, it's your money, tax day may be years off and you're paying back yourself -- not some credit card firm or payday loan company -- with interest.
But, while there are some pros to doing so, in general, financial experts say they are outweighed by the cons. Such retirement account loans are usually a bad idea and should only be considered as a last resort, they say.
"I'm not a fan of borrowing against a 401(k)," says Rick Irace, chief operating officer with the retirement division of Ascensus, a retirement, education and health care savings services provider in Dresher, Pennsylvania. "Take one only if you exhaust all other financial resources."
[See: 10 Important Investments Before Having a Baby.]
The positives. Taking a loan on your retirement plan isn't completely without advantages. There is no income tax or withdrawal penalty on a 401(k) loan unless someone defaults, Irace says.
Also, there's no long credit check, the application process is relatively simple and you can get the money quickly, he adds.
A 401(k) loan will have a cheaper interest rate than what you would pay on a bank loan or credit card, and you're paying that interest back to yourself, Irace says.
Noah Doyle, senior vice president for wealth management at New York-based Battery Park Financial Partners, is generally against retirement-plan loans.
But one exception he says he can live with is for people who use a 401(k) loan to help pay for the first home that is their primary residence. Tapping a retirement account for a vacation home or second home remains unwise, Doyle says.
"At the end of the day, your house is really an asset, it's not short-term consumption," he says.
The disadvantages. "There's more negatives to it than positives," says Lee Topley, managing director with the retirement plan consulting group at Unified Trust Co. in Lexington, Kentucky. "If someone has a dire situation, we would never tell anyone to not do it, but that should be the last resort."
His firm doesn't allow participant loans in its own retirement plans, he says.
Retirement funds are supposed to provide security when you stop working, not a place to dip into for immediate consumption, Doyle says.
"There is no pro in seeing this as a line of credit or a place in which you can get a loan," he says.
If you take a loan from your retirement plan, you're out of the market and forgoing potential gains on those funds, Irace says.
Also, you'll get taxed twice, he says. That's because you're using after-tax funds to repay the loan, and then you'll be taxed when you ultimately withdraw the money in retirement, he says.
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty.]
Further, if you're funneling money to repaying the loan, you're likely to contribute less to your plan, he says.
And that's for plans that even allow contributions at the same time as an outstanding loan. If you can't contribute to your plan, that means you're probably missing out on your company's matching funds, Topley says.
If you have an outstanding loan and cease work with an employer, you may only have 60 days to repay the balance, Irace says. If you don't repay, it becomes a distribution and subject to income tax and a 10 percent penalty if you're younger than 59.5, he says.
For those hoping to use a 401(k) loan to pay off debt, they can end up in a worse situation if they don't get their finances in order, he says, since funds in a 401(k) are protected from creditors.
Even though you're paying yourself back, Topley says the low interest rates on 401(k) loans mean that you're not getting that great of a return.
"Plan administrators make 401(k) loans too easy," Doyle says. "These are not credit cards. It should not be easily accessible."
So what are better options if you need the money? First, you shouldn't be putting money away in a 401(k) unless you have basic liquidity needs met, Doyle says.
At a minimum, he recommends having three to six months of cash on hand, or at least $10,000 in emergency reserves, before funneling money from your paycheck into a retirement account.
Topley recommends a personal loan from a local bank as a better option than a retirement-plan loan. Or, for homeowners, a line of credit on their home equity is also preferable to tapping the account that is supposed to be earmarked for your golden years.
If the cash need is for health care, there may be a plan available to pay off medical bills over time, he says. The same may be true if you get into an accident and need to buy a new automobile, he says.
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"For those emergency scenarios, for the most part, most organizations and entities will work out some kind of a payment plan," Topley says.
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