If you find yourself in a financial pinch, you may be tempted to borrow from funds you've steadily tucked away in your employer-sponsored 401(k) plan. While some 401(k), 403(b), and 457(b) plans allow participants to borrow from their accounts, that's not the case for all plans. It's up to the sponsor to determine whether to include loan provisions.
The first step is to check with the plan sponsor or the Summary Plan Description to learn whether a loan is possible. The next (and more important) step is to examine other options available to you.
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You may have alternatives
As with most financial decisions, it pays to examine your options before making a final decision. Before moving forward with a 401(k) loan, consider these four alternatives: personal loans, a new credit card, a home equity loan, or selling some assets.
Personal loan
Personal loans are available from banks, credit unions, and online lenders. Most personal loans are unsecured, meaning you don't have to provide collateral. However, you could provide collateral, making it a "secured" loan; in that case, chances are you'll snag a lower interest rate because the lender knows it can repossess the collateral, sell it, and recoup its losses if you fail to make payments.
Personal loans typically have a fixed interest rate: You pay the same amount each month until the loan is fully paid. How much you're eligible to borrow and the interest rate you'll pay are determined by factors like your income and credit score.
New credit card
If you have a strong credit score, you may have access to one of the credit cards with a 0% introductory interest rate that issuers use to lure new customers. Here's how it works: You apply for a new credit card advertising a 0% intro rate. Typically, the rate will last between 12 and 24 months. That means you don't have to pay interest on the debt until the end of the promotional term, and if you play your cards right, you won't have to pay interest on the loan at all.
Imagine that you qualify for a card with a 0% promotional rate for 18 months, and you spend $10,000 to make home repairs. By making a monthly payment of $555.55 for 18 months, you'll pay off the entire $10,000 and never pay a penny in interest ($555.55 x 18 = $10,000).
There is a catch, though. If you don't pay off the entire balance by the time the promotional rate expires, the annual percentage rate (APR) will shoot up to the standard rate, and you could find yourself stuck with expensive credit card payments.
Home equity loan
If you own a home, a home equity loan allows you to borrow money using the equity in your home as collateral. As with any other secured loan, the lender can repossess the collateral (your home) if you fail to make payments. However, if you can swing the payments, you can typically land a fair interest rate.
Equity is the difference between how much your home is currently worth and how much you still owe on the mortgage. For example, if your home is worth $300,000 and there's $150,000 remaining on your mortgage, the equity in your home is $150,000.
Selling assets
Consider selling any assets that can bring in the money you need. These could be anything from a parcel of land to a classic car or a high-value piece of art. You might even sell an assortment of smaller, less valuable items.
Why does it matter?
There's nothing inherently wrong with borrowing from a 401(k). After all, it's your money. The issue is whether doing so is the wisest financial move. The following points make the case for at least looking into alternatives.
Borrowing from your 401(k) can be expensive
Let's say you want to withdraw money from your 401(k) to start a business. In addition to repaying the 401(k) loan in five years, you'll have to come up with any extra money required to cover everyday business expenses you didn't count on, such as repairs and higher-than-expected inventory costs.
Any money you don't pay back by the due date is subject to income taxes, and if you're younger than 59 1/2, you'll also be hit with a 10% penalty.
In other words, unless you're confident that you can make all payments as agreed while also seeing to your other financial obligations, a 401(k) loan may not be right for you.
You press the brakes on portfolio growth
Any money pulled from your retirement account is no longer available to purchase stocks, bonds, and other potential growth vehicles. Even if the borrowed funds go directly from your retirement account into a savings account, the rate paid on the savings account is unlikely to come close to the rate you would earn over time by leaving it in the 401(k). Allowing funds to remain in a retirement account over the long term presents opportunities to pick up assets at a bargain price and fatten your portfolio in the process.
You deal with double taxation
When you first contribute to a traditional 401(k), that money is not counted as taxable income. And when you borrow from a 401(k), you withdraw the funds tax-free. Sounds good, right? However, there's a catch.
Let's say you take money from your paycheck once a month to repay the loan. Those funds will be taxed at your regular tax rate. Years later, when you begin taking withdrawals from your 401(k) in retirement, you'll pay taxes on the funds withdrawn -- again.
In addition, you must repay your 401(k) loan with interest. Yes, you're paying the interest to yourself, but it still adds to the cost of the loan.
While it may be doable, borrowing from a retirement account is rarely your best option. Before diving into a 401(k) loan, study the alternatives to learn if one might be a better fit for you.
