Think carefully before borrowing from your 401(k)

The Savage Truth

There's a simple rule when it comes to borrowing from your 401(k) retirement plan at work: Don't do it!

Just because 90 percent of companies allow participants to borrow from a 401(k) plan doesn't mean it's a good idea. A new study shows that 14.6 percent of participants have an outstanding loan, with an average amount of $6,216, and the typical loan duration of five years before repayment.

Now, as we enter the second month after the holiday shopping spree, it's tempting to grab any available cash to pay down those credit card balances. And as tax season arrives, it's also tempting to borrow to pay any additional taxes due. But forget borrowing from your 401(k) plan. There are many perils and costs, which you probably haven't considered.

Here are five things to keep in mind about borrowing from your 401(k) or similar defined contributions retirement plan.

Investment cost

Many people justify borrowing because they know they will repay the loan with interest to themselves. In 2014 the average loan rate was 4.09 percent, but some plans charge a floating rate based on the prime rate. It is definitely less than the interest you will pay on a credit card or on late payments to the IRS.

However, it means that you are losing all the growth on that money during the time it is out of your account -- and future growth that the money would have generated. If you borrow while the market is on an uptrend, you may never make up the forgone growth.

Borrowing and repayment rules

Each company sets its own rules, within certain DOL limits, about how much you can borrow and how you must repay. You certainly won't be able to borrow all the money in your account; loans are usually limited to either $50,000 or half of your plan assets. Typically, you have to repay money you've borrowed from your 401(k) within five years by making regular payments of principal and interest at least quarterly, often through payroll deduction.

Job loss

If you lose your job, your plans to slowly repay the loan may be abruptly changed. If you fail to repay the loan within 60 days of losing your job, you will be considered to have defaulted on the loan. That will require you to pay ordinary income taxes on the amount you took out -- plus a 10 percent federal tax penalty if you are under age 59 1/2.

Changing jobs

The same rules apply if you change jobs, requiring a loan repayment -- even if you leave your 401(k) plan at your former employer. When you leave employment, the loan must be repaid. This weight could make it costly to take a better job with more opportunities.

Penalty Cost

While studies show that 90 percent of 401(k) plans are repaid, the remaining 10 percent who do not repay the loans within the plan's prescribed time frame or within 60 days of a job loss account for a huge amount of taxes and penalties. The Pension Research Council estimates that loan defaults generate more than $1 billion in annual tax revenues each year!

There are a few penalty exemptions, such as if you withdraw from a 401(k) for large medical bills or owing to a qualifying disability. However, be aware that, unlike with IRAs, there are no penalty exemptions in a 401(k) for borrowing for education expenses or a first home purchase.

Your retirement plan may look like a tempting pot of money, ready to be borrowed. There is little paperwork and no credit check required. But the consequences of borrowing could be more expensive than you realize, both now and in the future. That's The Savage Truth.

Terry Savage is a registered investment adviser and the author of four best-selling books, including "The Savage Truth on Money." Terry responds to questions on her blog at TerrySavage.com.

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