Personal Finance: When to borrow from 401(k) funds

Personal Finance: When to borrow from 401(k) funds

September 21st, 2011 By Chris Hopkins in Business Diary

Q: I am experiencing financial difficulties. Can I borrow from my 401(k)?

A: Maybe. Generally speaking, it is not recommended that you dip into tax-deferred retirement savings to meet current obligations. However, there may well be circumstances that justify such action and under which a 401(k) loan could be the best course of action.

Retirement savings plans like 401(k) accounts under which employees contribute from their own pre-tax earnings are referred to as defined contribution plans. Contrasted with defined benefit (pension) plans, defined contribution plans accumulate the employee's own salary deferrals, often matched in part by contributions from the employer. The law allows for loans from such plans under certain circumstances.

While your deferrals should typically be considered off limits until retirement, some financial demands may justify tapping the plan for a loan. Falling behind in payments on a mortgage or an agglomeration of unexpected medical expenses could certainly warrant borrowing from the account, especially if no other resources are available.

If you think a 401(k) loan makes sense, check with your employer to find out if your specific plan has a loan provision. Although such loans are sanctioned by labor law, some employer plans do not allow them or limit the acceptable reasons for establishing a loan.

In general, you are limited to borrowing up to 50 percent of your vested balance or $50,000, whichever is less. Again, specific plans may have lower borrowing limits. You will be required to sign a promissory note that obligates you to repay the amount with interest at a competitive rate (say, prime plus 2 percent). In the present low rate environment, your interest rate could be as low as 5-6 percent.

Loans must typically be serviced in regular installments no less frequently than quarterly, usually in the form of a payroll deduction, and must be fully repaid within five years.

While 401(k) loans are quite simple to initiate (if allowed by the plan) and require no credit check, there are certain caveats of which the borrower should be fully aware.

Many employers will not allow you to continue making elective deferrals as long as you have an outstanding loan balance. This will of course impinge upon your future retirement security. Furthermore, if you leave your job for any reason during the loan period, you must make full repayment within 60 days of separation. Otherwise, the unpaid amount will be considered a distribution and will be subject to income taxes and a potential penalty if you are less than 59 years old.

And don't forget human nature. The ease of establishing a loan may present a temptation to borrow for a less worthy expenditure. In what must be the worst idea since the Edsel, some retirement plan administrators are actually promoting a 401(k) debit card to expedite your decent into penury during your golden years.

Taking a loan from your retirement plan should be considered a last resort, but under sufficiently exigent circumstances the ability to borrow from yourself could be a lifesaver.

Chris Hopkins is vice president, investments, at Barnett & Co. Inc.