Friday Encore: Is it ever okay to borrow from your 401(k)

Welcome to the Friday Encore where you'll get to read a past blog posting that I thought you might not want to miss. Okay, call it a repeat if you want. When necessary the post may be updated with new information or data to keep it relevant. The following was originally posted March 19 2008.

Is it Ever Okay to Borrow from Your 401(k)? by silverbelly

UPDATE: In the last weeks of the 2008 presidential campaign both candidates unveiled 401k and IRA borrowing as options as part of broader plans to bailout the middle class. For now these are just campaign promises. Don't be confused in thinking that they are law. Know all the implications of borrowing against your retirement before you take a dip.

Borrowing from your 401(k) is more like taking a loan than tapping into your own retirement savings, mostly because it's administered by your employer and because it's a pre-tax account. Most employers allow you to tap your account for things that qualify like buying a house, college or to repay debt. Here's the good, bad and possibly ugly of borrowing from the 401(k).

Good

1. It's fairly easy and convenient. Just talk to your human resources department.
2. If you are using your 401(k) funds to pay off high interest loans, you'll save money by borrowing at a lower rate.
3. It's not technically a loan, so there are no credit checks.
4. You'll have 5 years to pay it back (unless you leave the company, see below).

Bad

1. You'll lose interest. The money you take from your 401(k) is no longer appreciates in value from interest, dividends and/or capital gains.
2. Employers have the option to charge initiation fees for paperwork, etc.
   

It could get ugly...

1. If You Leave Your Job: The money you still owe to the account will be due in a lump sum shortly after leaving. If you are younger than 59.5 years you'll also pay a 10% federal penalty.
   
2. Not Tax-Sheltered: Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars. Let's say your monthly interest payment is $300 and you're in the 28% tax bracket. You'll have to make $416 in gross earnings to make the $300 payment. Then, when you retire and take withdrawals, you pay taxes yet again.
3. Not Tax-Deductible: This is considered a consumer loan, so there is no tax advantage.
   If You Can't Pay it Back: You'll pay taxes as if the loan were ordinary income (higher) and you'll pay that 10% penalty if your are under 59.5 years.

So is it ever okay to borrow from your 401(k)? Sure. As long as you understand all of the possible implications. If you own a home a better bet might be to look at a home equity loan. At least with this loan you're more likely to be able to get a tax break on the interest paid.