Borrowing from Your 401(k)
Most 401(k) plans include a loan feature that allows you to borrow money from your retirement account and repay it in five years or less at an interest rate determined by your plan administrator, usually a couple of points above the prime rate. Most plans with a loan feature allow you to borrow half of your balance, up to $50,000.
Paying Yourself Back
Since you pay the interest back into your own 401(k) account, you may think you can't go wrong with a 401(k) loan, but it's not quite that simple. Remember the discussion of opportunity costs in earlier sections? Taking money out of your account could have a significant impact on your retirement income even though you pay the money back, because you have less money invested to earn interest and dividends or appreciate in value.
There could be a double whammy if you reduce your contributions to the plan because you can't afford to make contributions in addition to the loan payments. Even if your loan is repaid in one year, going that long without new contributions will have a long-term impact on how much you accumulate by the time you reach retirement age. Still, there are times when using 401(k) funds to get out of a credit hole does make sense.
The Danger of Changing Jobs
Perhaps even worse than reducing the potential accumulation of earnings is the danger of being stuck with a loan balance if your employment terminates, whether it's because you've accepted a job elsewhere or you were fired or laid off.
If you have an outstanding loan at the time your employment ends, you'll have to pay it back immediately to avoid having Uncle Sam slap you with taxes and a 10 percent penalty.
Using your 401(k) to pay off debts is dangerous. Your 401(k) is there to help you in future years. If you start spending that money now, you might end up with nothing in retirement. It's harder to borrow, cut costs, and work more hours in retirement.
Let's say you borrowed $12,000 and repaid $2,000 before changing jobs. Your loan balance at termination is $10,000. If you can't come up with the money to repay it right away, it will be considered a premature withdrawal. If you're in the 28 percent tax bracket, you'll have to pay $2,800 in income taxes, plus another $1,000 (10 percent) early withdrawal penalty. All of a sudden your low-interest loan doesn't look so good.
On top of that, if you have no other way to come up with the money to pay the taxes and you have to take them from your 401(k) plan too, that money will also be subject to taxes and penalties. The retirement fund that you've worked so hard to build could be decimated. In most cases, 401(k) loans should be used as one of the last options for debt consolidation.
