Published: February 14, 2009 04:40 pm      

Think twice before taking out 401(k) loan

Your car could break down. You might need a new furnace. You have to pay for one last term of college for your child. Whatever the reason, you may someday need a large sum of money in a hurry. And as you look around for a source of funds, your eyes might come to rest on your 401(k) plan. It’s there, it’s yours — why not tap into it?

Actually, there are some pretty good reasons for not dipping into your 401(k). But before we get to those, let’s see how you might access the money in your plan.

Some employers allow 401(k) loans only in cases of financial hardship, although the definition of “hardship” can be flexible. But many employers allow these loans for just about any purpose. To learn the borrowing requirements for your particular plan, you’ll need to contact your plan administrator.

Generally, you can borrow up to $50,000, or one-half of your vested plan benefits, whichever is less. You’ve got up to five years to repay your loan, although the repayment period can be longer if you use the funds to buy a primary residence.

So you’ve got some time to repay the loan, you’re paying yourself back with interest, and the repayments are probably just deducted from your paycheck. Sounds pretty good, right? What could be the problem with taking out a 401(k) loan?

Since you asked, here are a few of them:

• You’ll likely reduce your retirement savings. Your 401(k) plan is designed to help you build funds for one purpose: retirement. To encourage you to take advantage of your 401(k), the government defers taxes on your earnings and allows you to make contributions with pre-tax dollars. But when you take out a loan from your 401(k), you are removing resources earmarked for your retirement. And even though you’ll repay the loan, you can never get that time back when your money could have potentially grown.

• You’ll be taxed twice on the loan amount. As mentioned, you typically contribute pre-tax dollars to your 401(k). But when you repay the loan, you’re doing so with after-tax dollars. When you withdraw the money at retirement, it will be taxed again.

• You’ll have to quickly repay the loan if you leave your job. If you leave your job, whether voluntarily or involuntarily, you’ll generally be required to repay the loan in full within 60 days. If you don’t repay it by then, the outstanding balance will be taxable — and if you’re under 59 1/2, you’ll also have to pay a 10 percent penalty tax.

To avoid putting yourself in the position of having to someday borrow from your 401(k), try to build an emergency fund containing six to 12 months’ worth of living expenses. Keep the money in a liquid account so that you can tap into it quickly.

It can be tempting to borrow from your 401(k) today — but if you can resist this temptation, you’ll almost certainly be glad tomorrow.