Borrowing From 401(k) Should Be a Last Resort

Cash-strapped consumers are developing a bad habit: using their retirement savings to tackle everything from credit-card debt and late mortgage payments to income tax bills.

In 2007, 18% of employees reported taking out a loan from their 401(k) or 403(b) (the employer-funded equivalent for public educators and nonprofit employees), up from 11% in 2006, according to the Transamerica Center for Retirement Studies, a nonprofit. Of those borrowing, 49% said they needed the money to pay off debts, nearly twice the number that previously cited that reason. Major employer-sponsored retirement plan providers, including Fidelity Investments, J.P. Morgan Chase and T. Rowe Price Group, have reported similar trends. The average outstanding loan balance: $7,292.

"Consumers are dipping into their 401(k) accounts because they don't have any other options," says Mark Nash, a partner at PricewaterhouseCoopers' Private Company Services Practice in Dallas, which advises clients on retirement issues. The credit crunch and slumping real estate market have limited homeowners' ability to secure home equity loans. Combine that with a national savings rate that has languished near zero percent since 2005 and consumers have few accessible liquid assets with which to handle a possible job loss, wage decrease or crippling debt.

In dire situations like these, borrowing from your 401(k) may seem like the best recourse; it is your money, after all. And instead of paying the plan provider interest, you're paying yourself interest. Borrowers can access up to $50,000 or half their balance, whichever is less, with minimal paperwork and no credit check. "It's almost a shoe-in as far as a loan goes," says Gerri Detweiler, credit advisor for Credit.com. Some companies have made it even easier to gain access to 401(k) cash. They're allowing employees to allocate part of their 401(k) balance to a high-yield money-market account, then providing them with a debit card that lets them withdraw those funds as a loan.

But borrowing from your 401(k) can do far more harm than good. "There's only one reason to prematurely dip into your 401(k) — you've got a loan-shark named Louie waiting outside your door with a baseball bat, waiting to break your kneecaps," says Patrick Astre, author of "This Is Not Your Parents' Retirement." Even then, it might not be your best bet.

Carefully consider these five reasons to leave your 401(k) or 403(b) intact:

The markets should recover

"We're in an environment where it's not a good time to be pulling money out of the market," says Brad Levin, a certified financial planner and president of Legacy Wealth Partners in Encino, Calif. "Prices are down, and they're going down." Depleting your balance hits harder — if you've seen your balance drop 6% since the beginning of this year (about the same amount that the Dow Jones Industrial Average has fallen), taking out a loan of $10,000 now would be the equivalent of borrowing more than $10,600 at the beginning of January. You'll also miss out on potential returns when the market comes back to life. "If the market turns around, you're limiting your returns to whatever your interest rate is," says Nash. "You've essentially put your 401(k) into a fixed-income investment." Depending on your company and plan provider, that might be as little as 5%.

Compound savings

Borrowing from a retirement savings account also means missing out on that money's ability to compound from now until retirement. "You're taking a giant step back from being able to retire," says Harry Wendroff, CPA and managing partner of Buchbinder Tunick & Company, LLC in New York. A 35-year-old man with a 401(k) balance of $25,000, for example, could save $757,409 for retirement by age 65 (assuming 8% annual returns, a contribution of 7% of his $50,000 salary and no company match). But if he took a $10,000 loan and repaid it over five years, he'd lose $25,892 of that amount. If he halted contributions while he was repaying the loan, the loss grows dramatically to $132,171.

One less payment (with interest) to make

"A loan from your 401(k) is ultimately another monthly payment to make," says Nash. Borrowers pay back the loan with post-tax dollars, a much bigger bite than pretax contributions. Someone in the 35% tax bracket, for example, would need to earn about $13,500 pretax to pay off a $10,000 loan — and that's before factoring in interest or loan administration fees to your employer.

A stronger safety net

"Sometimes people take out these loans just to keep the wolf away from the door," says Detweiler. Even if circumstances are dire, think twice. Pension, 401(k) and IRA assets are among the few that cannot be seized by creditors. Try all other options (see below) before dipping into these protected accounts.

A reduced tax hit

Should you leave your job or get fired, the balance of any outstanding 401(k) loan comes due immediately. If that balance isn't paid off within three months, the loan becomes a taxable withdrawal. Borrowers will owe a 10% penalty in addition to regular income tax. Someone in the 35% tax bracket with a loan balance of $10,000 would owe another $4,500 in taxes and penalties. Wait until you retire to tap your account, and you'll merely be taxed at the then-current income tax rate for distributions.

Alternatives to Raiding Your 401(k)

Dipping into your 401(k) or 403(b) should be a loan of last resort. Before you derail your retirement, make sure you've explored other possibilities. Of course, you should also aim to curb spending and cut out unnecessary expenses. "Resolve to spend 10% less and earn 10% more," says Astre. Here's what else to try before dipping into your retirement funds:

Temporarily halt 401(k) contributions. The average worker stashes 7% of his salary in a 401(k), according to Fidelity Investments. For someone making $55,000 a year, temporarily halting contributions would put an extra $111 in their after-tax paycheck every two weeks. This still isn't a great option — you'll be forfeiting any company match and limiting future compounding — but you'll at least maintain the earning power of your current balance.

Apply for a home equity loan or line of credit. True, the credit crunch has made it tough for consumers to dip into their home's equity, especially those who don't have much to begin with, or live in areas where property values have taken a nosedive. But that doesn't mean you shouldn't try. Like borrowing from your 401(k), a HELOC or HEL uses money you've already accrued. The difference is that you're not losing compound interest on your balance if you take out a loan.

Borrow against insurance. If you have a cash value life insurance policy (and more than half of those sold are) you can borrow against it without paying any tax penalty, says Levin. Your death benefit will be diminished by the amount of the loan, including interest, until it's repaid.

Sell investments. Selling in a down market isn't a great investment strategy. But for those who have dabbled in the stock market beyond their retirement savings, selling some stocks has fewer consequences than borrowing from your 401(k). "The long-term capital gains tax is much cheaper, comparatively," says Nash.

Consider financing. See if you can work out more favorable loan terms with lenders, advises Detweiler. The IRS, for example, offers installment plans to pay income tax. Or you might work with a credit counselor or debt-settlement company. Just make sure to do your research first, or else you'll end up paying more than your debt is worth.

Tap your IRA. In certain circumstances, such as if you're first-time home buyer or if you can repay the money within 60 days, you can make an early withdrawal from your IRA without paying too much of a price.