by Marcy Kennedy

Created on: January 15, 2009

No one plans on borrowing from their 401(k) when they start investing for retirement, but when a financial emergency hits, this may seem like your only option. Before you start dipping into your 401(k) rather than taking out a conventional loan, however, carefully consider the advantages and disadvantages.

ADVANTAGES OF BORROWING FROM A 401(K) PLAN

(1) You can borrow 50 percent of your 401(k) balance, up to $50,000.

(2) You don't have to go through the qualification process that goes along with a conventional loan since you are taking out your own money.

(3) You receive your money quickly, often within one week of application.

(4) Your interest rate will be much lower than what you would normally receive from a conventional loan. On average, you will receive the current prime rate plus 1 percent. For a look at the U.S. prime rate history or for the current prime rate, visit www.currentprimerate.info.

(5) The interest is paid back to your account.

DISADVANTAGES OF BORROWING FROM A 401(K) PLAN

(1) You have a maximum of 5 years to repay your loan. The only exception is the extended loan period of 10 years given to those using the loan for a down payment on a home. If you default on paying back your loan in this time period, your loan will be called a withdrawal. The government will charge you income tax on the money and a 10 percent early withdrawal penalty (since you took the money out before age 59.5).

(2) You are stalling your retirement savings. You cannot make contributions to your 401(k) other than repayments until your loan is paid back, and the money you have withdrawn will not grow while it is out of your 401(k). In most cases, you will also be barred from making contributions to your 401(k) for 6 to 12 months after you have repaid your loan.

(3) Your take-home pay will be reduced since your payments will be deducted from your paycheck.

(4) If you are fired from your job, the full outstanding amount on your loan will be due in 60 days. If you cannot pay within those 60 days, the loan will be considered an early withdrawal, and you will be penalized accordingly.

For example, if you withdraw $20,000 to pay your medical bills and then lose your job, you will have to repay that $20,000 within 60 days whether you are able to find another job or not. If you fail to repay the full amount, the government will request that you pay $6000 or more in taxes and penalties. Since the money you withdrew to pay your medical bills is gone, you will have to find another way to pay the taxes and penalties. You may end up with bigger financial problems than you had before you borrowed from your 401(k).

(5) If you leave your current job for any reason, even to move to another job, the full outstanding amount will be due in 60 days. If you cannot pay, you will suffer the same consequences as if you defaulted or were fired and could not pay your loan.

Depending on your situation, borrowing from your 401(k) plan may be a good idea or a bad idea. Whichever route you choose, do not make your choice lightly.

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