Is it a good idea to borrow money from your 401(k) plan? In an emergency, yes. Otherwise, no.
Unfortunately, many people treat retirement savings as a rainy-day fund. At the end of 2010, almost 28 percent of people with 401(k)s had loans against them, according to a study from consulting firm Aon Hewitt. That's a record number and continues an upward trend.
Almost 70 percent of those who leave a job and have a loan against their 401(k) will ultimately default on it. What happens when a person defaults on that loan? The amount of the loan becomes taxable income, and, if you're under age 59 1/2, you'll have to pay a 10 percent early withdrawal penalty. Beyond that, it has a huge impact on potential earnings in your retirement account. Click here to see how your future potential balance would be affected if you default on a loan from your 401(k).
These recent trends led two U.S. senators to propose legislation designed to protect us from ourselves. Their proposal—the SEAL Act—would help prevent 401(k) participants from using their retirement plan as a rainy-day fund. If approved, the act would do several good things:
1) Limit the number of outstanding loans against a 401(k) to three. While many plans allow only one loan at a time, there is no legal restriction, so theoretically you can take out an unlimited number of loans against your 401(k). That's a really bad idea, because it lets you use your 401(k) like a checking account.
2) Allow 401(k) participants to contribute money to their plan after they take a hardship withdrawal or loan against the 401(k). The new rule will permit you to continue making contributions to your plan, even during the first six months after a hardship withdrawal, encouraging people to continue putting money in their retirement plan account while paying off loans.
3) Ban debit cards linked to 401(k) plans. If you have a debit card linked to your 401(k), you can go to Best Buy and charge a new TV against your retirement account. I strongly advise against doing that, even if the SEAL Act doesn't become law.
Generally, your 401(k) account should never be used as a rainy-day fund. However, sometimes you might need money in emergency situations. If you have a medical emergency or if you or a family member gets seriously ill, it doesn't matter how much money is in your retirement plan. Or maybe you've lost your job and are about to lose your house. Borrowing from your retirement is justified in these cases. Some things in life are just more important than money.
However, many situations don't make sense. A caller to my radio show told me she borrowed money from her 401(k) because she wanted her daughter to have a "dream" prom. She bought her daughter a $600 dress, and paid for her nails, hair extensions, and limo rental. That's a bad idea.
Another bad idea: paying off your credit card debt by borrowing money from your 401(k). After paying off your credit cards, what if you resume your spending habits. Before too long, you'll have balances on your cards. Plus, you'd still have the loan against your 401(k). That's not good.
If you do have an emergency or hardship situation, here are a few things to consider before you borrow money from your 401(k):
Repayment. For most 401(k) loans, repayment plans range from one to five years. Loan payments are automatically deducted from your paycheck.
Double taxation. Your retirement plan contributions normally are made with pre-tax dollars. This means your taxable income is reduced each year by your contribution amount. Your contributions (and earnings) are taxed when you withdraw money. When you take a loan from your plan, you may be subjecting yourself to additional taxes. Loan repayments are made with after-tax money, and repayment amounts will be taxed again when you withdraw money.
Diminishing compounding. Compounding interest is one of the greatest assets when investing for retirement. Over time, the interest and gains on the money in your 401(k) can accumulate significantly. When you pull money out of that account, you reduce the amount available for compounding. Though you repay the loan with interest, it doesn't necessarily make up for the time lost when the money is outside your account.
Leaving your employer. If you leave your job or your employer lets you go before your loan is repaid, the outstanding balance after a certain period (generally 60 days) is considered a distribution. Distributions are subject to taxes, and a 10 percent early withdrawal penalty may apply if you're under age 59 1/2. In some circumstances, your distribution may qualify as a hardship withdrawal and would not be subject to the early withdrawal penalty. Ask your advisor for tax information on any distributions from your retirement plan account.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast to coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.
Corrected 6/29/2011: A previous version of this story incorrectly stated the number of people who default on 401(k) loans.