Most 401(k) retirement plans allow participants to borrow from their accounts within the retirement plan.  This source of funds can be helpful if you need money but is not always the best solution.  Here are some of the issues to consider before making the decision to borrow from your retirement plan.

Why borrow at all?

Borrowing from any source is an important decision.  If you really need the money, borrowing can help you get what you need.  However, borrowing also brings a responsibility for repayment.  Before borrowing from your 401(k) plan, make sure you are going to get lasting value with the funds.  Borrowing for a down payment on a home or a college education is probably a better decision than borrowing to take a vacation or buy an expensive gift.

What are the costs of borrowing from your 401(k) plan?

There are really two “costs” of borrowing from your 401(k) plan – the actual interest rate you pay (and any loan fees the plan charges) and what the borrowing will do to your long-term retirement planning success.

Many plans enable you to borrow up to 50% of the value of your account to a maximum of $50,000.  The interest rate you pay is usually one to two percent above the existing prime rate and will change as the prime rate changes.  Be sure to review the details of your plan for specifics.  The current (April 2015) prime rate of 3.25% would mean a rate of 4.25% to 5.25% which compares very favorably with rates on most credit cards, but less favorably with home equity loans which are sometimes offered at something less than the prime rate.

The other “cost,” to consider is whether taking a loan from your 401(k) plan will help or hurt your long-term retirement planning.  The interest you pay on a 401(k) loan goes back into your account because you are really the lender.  Taking money out of your plan with a loan means that those funds are not invested and earning the way the rest of your funds are.  Even though you are “paying yourself interest,” your total retirement nest egg is growing more slowly.

Another item to consider is whether your plan administrator charges a fee for handling a loan.  Be sure to ask.

How are you going to repay the loan?

Most plans require you to repay loans within five years unless you use the loan proceeds to help buy a first home.  Employers can usually set up an automatic plan to have part of your paychecks go directly into your plan to repay the loan.  But, you still have to repay it.

Another repayment issue to consider is what happens if you change jobs while the loan is outstanding.  Most plans require you to repay any outstanding loans immediately if you change jobs.  If you don’t (or can’t), the IRS may consider the loan to be an early withdrawal subjecting you to income tax on the amount and potentially an additional 10% tax if you are under the age of 59 ½.  Think twice about a loan from your 401(k) plan if a job change is in your plans.

What about income tax consequences?

Borrowing from your 401(k) plan does not trigger income taxes, provided you repay the loan in the required timeframe, or immediately if you change jobs.  Since the earnings on funds within your plan are tax-deferred, the interest you pay does not trigger any income taxes.  However, that interest you pay cannot be treated as an itemized deduction on your individual tax return.

Are there alternative borrowing sources to consider?

Your 401(k) plan assets will probably be one of the most important sources of income when you retire.  As such, you want your plan balances to grow as quickly and as much as possible.  Taking a loan will probably slow down that growth.

Borrowing through a credit card is probably not a good idea because of higher rates.  In addition, interest paid on credit cards is not tax-deductible.

A home equity loan may be a better alternative.  Many home equity loan programs provide lower interest rates and the interest paid on a home equity loan may be tax-deductible if you itemize your deductions on your individual tax return.

Summary

Borrowing from your 401(k) plan is a beneficial feature of this type of retirement plan.  The interest rate on the loan will probably be relatively low and having up to five years to repay the loan can be attractive.  It is probably easy to get a loan.  Your plan administrator or human resources department should have the papers you need and there is no loan approval process.

However, like any other loan, it must be repaid.  In addition, the costs of slowing down the growth of your retirement portfolio and the non-deductibility of interest paid should at least make you consider all your alternatives.