Lots of people are tempted to borrow from their 401(k). In this article, Cheryl Curran tells why this is a bum idea.

From time to time most of us feel strapped for cash for major items. A son or daughter is getting married, or the house needs a new roof or the vacation home we’ve always wanted is suddenly on the market. If we don’t have the money, we start looking around. The 401(k) we’ve been accumulating over the years may look like a juicy bank account just waiting to be tapped.

When you borrow from such a plan (assuming that your plan allows a loan), you are both the borrower and the lender, so there’s no credit check. And the interest rate is probably lower than you’d find at a bank. All that it may take is a phone call and a signature. What could be simpler? A lot of things, it turns out.

The interest rate may be low and the cost of that interest may seem free because you're paying it to yourself. But under the rules for 401(k) plans, you will eventually be taxed twice on every penny of that interest. You’ll never have to understand the details if you take my advice: Don’t raid your 401(k) unless you have a serious need for money and you have exhausted all other options. Here’s why I say that:

First, once you borrow the money, it’s no longer working for your retirement. Many plans require you to pay back the loan before you can make additional contributions.  If you take five years to repay the money, that’s five years of 401(k) contributions you aren’t making. If you’re 40 years old and would normally contribute $8,000 a year, and if your account grew at 8 percent, that’s $218,000 that you would not have at age 65.

Second, it has become very obvious over the last decade that it doesn’t matter what company you work for or how long you’ve worked there, you can quickly be out of a job. If for any reason you wind up no longer employed at your company, whether this separation is voluntary or involuntary, you will have to pay back the full amount of the 401(k) loan right away. This punch will hit you when you will be least able to come up with the money.

Any outstanding loan balance that you don’t pay off before you leave that job will be taxable income to you. You’ll never be able to restore that money to any other 401(k) plan. If you’re under 59 ½, you’ll pay a 10 percent tax penalty as well. If you had a $40,000 outstanding loan, you would owe $4,000 in penalty plus income taxes of $8,000 that year – and maybe more. That loan you thought was so cheap would instantly become extremely expensive.       

Third, borrowing from your 401(k) can have a long-term negative effect on your attitude toward savings. If you regard your 401(k) plan as a savings account that’s available any time you’ve overspent your income, you will probably wind up working several years longer than your peers, with less to show for it.

I hope you’ll think about this before you give in to the temptation of borrowing and then spending money that you and your family will need later.
 

Cheryl Curran is a Certified Financial Planner and a Merriman financial advisor.