Should you borrow money from your own 401(k) plan? Although most plans today make it very easy and economical, 401(k) loans may end up getting in the way of your long-term retirement goals.

Before considering a 401(k) loan, check the plan document to make sure it does allow borrowing and to find out what the terms of the loan will be. Most plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less. The maximum term is generally five years, the only exception being loans for the purchase of a first home, which can have a longer payback period.

The interest rate is usually much lower than a commercial lender could offer. The rate is set by the plan document and usually runs only one or two percentage points above the current prime rate. You pay the interest back to yourself, so your account balance continues to earn. While the interest rate usually isn't that high, it still beats the 3-4% return you would earn on most money market funds. Tax to be paid on interest earned is deferred until you withdraw your entire balance from the plan.

Your 401(k) plan may be the easiest and most convenient way for you to get yourself a loan. Many plans only require a short loan application form instead of the massive amount of paperwork usually required by banks and lending companies. Because you are borrowing from your existing balance, there is no credit check. For some people, a 401(k) loan may be the only option.

If you default on your loan and are younger than 59, you will be subject to a 10% early withdrawal penalty, along with the applicable federal and state income taxes. Also, there is no tax advantage for the interest you pay back. 401(k) loans, even those for the purchase of a home, are classified by the IRS as consumer loans, not mortgages, so you do not get the deduction for loan interest. You'll also have to pay taxes on that money again when you withdraw it at retirement (or sooner if you change jobs and cash out your account).

The most damaging effect of taking a loan from your 401(k) plan is the hit you'll take in compound interest over the years. The money you borrow from your retirement account can no longer earn tax-free interest and dividends during the loan period. The only gain on those funds is now your loan interest, which usually is at a lower rate and is paid in with after tax dollars.

Despite all of the disadvantages, 401(k) loans are still preferable to hardship withdrawals. If these are truly your only two options and you are under age 59, you should opt to borrow the money rather than take an early withdrawal and incur an extra 10% penalty.

401(k) loans can be a nice buffer against unexpected expenses, but they should be looked at as a last resort and taken only when absolutely necessary. Home-owners are far better off taking out a home equity loan because the interest on the loan is usually tax-deductible. Also, any and all savings accounts should be exhausted before resorting to pulling money out of your retirement plan. The tax savings and long-term compounding of earnings will far outweigh any short-term interest you may lose.

Learn more about this author, Christain Cullen.
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