Borrowing against your 401 (k) can seem like the closest thing to a dream loan. The interest is more often than not lower than most bank loans or lines of credit. All payments on interest and principle go directly back to you, helping to beef up your retirement savings. Installments can be as painless as regular deductions from your paycheck. And, your employer or 401(k) administrator probably won’t hassle you whether you need the money to skirt an emergency, pay tuition or foot a winter vacation in the tropics.
There are negatives to consider, though, before you fill out the loan papers. For one, although you’re in essence paying yourself interest, most likely the rate is less than the return you’d receive on many of the investment options in your current plan.
Another thing to mull over: that same sweet deal could pack a wallop in tax penalties you never imagined, particularly if you leave your job. Whether you quit, are laid off, downsized or fired, your balance typically becomes due and payable the minute you are terminated. If you can’t repay the balance in short order, it’s taxed as income. Even then, if you’re under 59 1/2, you’re in store for a 10% penalty to be assessed on the balance as well.
What can you do? To avoid a heavy tax penalty, you have the option to repay the loan, and roll your 401(k) over directly to an IRA or into your new employer’s retirement plan. If you don’t repay your loan, you can still avoid taxes if, within 60 days, you deposit cash in the amount of your loan balance into an IRA or your new employer’s plan.
That’s not to say that a 401 (k) loan is an absolute no-no. If your job seems stable, loan terms are attractive in comparison with withdrawing money early in case of an accident or an emergency and paying heavy taxes and penalties. “It’s the most tax-efficient way to get money while preserving your ability to save for retirement,” says Michael P. Barry, managing director and head of Plan Advisory Services at Bankers Trust.