The pros and cons of 401(k) loans

In today’s tough economy, many people are struggling to meet their day-to-day expenses. At the same time, the credit crunch has made it harder to obtain traditional loans. One enticing alternative may be to borrow against your 401(k) account, if your plan permits it. This can be a risky strategy, though, so it’s generally best considered only as a last resort.

Pros and cons

Many 401(k) plans allow participants to borrow as much as 50% of their vested account balances, up to $50,000. These loans are attractive because:

• They’re easy to get — you don’t have to worry about your income or credit score,

• There’s minimal paperwork,

• Interest rates are low, and

• You pay interest back into your 401(k) account rather than to a bank.

• Despite their appeal, 401(k) loans present significant risks and disadvantages:

• Even though you pay the interest to yourself, you lose the benefits of tax-deferred compounding on the money you borrow.

• You may have to reduce or eliminate 401(k) contributions during the loan term, either because you can’t afford to contribute or because your plan prohibits contributions while a loan is outstanding. Either way, you lose any future earnings and employer matches you would have enjoyed on those contributions.

• Loans, unless used for a personal residence, must be repaid within five years. Generally, the loan terms must include level amortization, which consists of principal and interest, and payments must be made no less frequently than quarterly.

Additionally, if you’re laid off, you’ll have to pay the outstanding balance quickly, typically within 30 to 90 days. Otherwise, the amount you owe will be treated as a distribution subject to income taxes and, if you’re under age 59¹/₂;, a 10% early withdrawal penalty as well.

The hardship withdrawal

Another option is to find out whether you can take a “hardship” withdrawal. For example, a plan may allow hardship withdrawals to pay certain expenses related to medical care, college, funerals and home ownership — such as first-time home purchase costs and expenses necessary to avoid eviction or mortgage foreclosure.

Keep in mind that, even if your plan allows such withdrawals, you’ll have to show that you’ve exhausted all other resources. Also, the amounts you withdraw will be subject to income taxes and, except for certain medical expenses or if you’re over age 59¹/₂, a 10% early withdrawal penalty.

Like plan loans, hardship withdrawals are costly. In addition to owing taxes and possibly penalties, you lose future tax-deferred earnings on the amounts you withdraw. But, unlike a loan, hardship withdrawals need not be paid back. And you won’t risk any unpleasant tax surprises should you lose your job.

A last resort

Given the high cost and risk involved, you should borrow or take hardship withdrawals from your 401(k) account only if you have a real emergency, you’ve exhausted your other financing options and you feel that your job is relatively secure. •