The Retirement Corporation of America

The Debate Over Borrowing From Your Nest Egg

LET'S SAY THAT one fine day, you suddenly need some money. Maybe you need more cash to make the down payment on a house. Or maybe there is a medical emergency with bills that are straining your rainy-day fund.

You could borrow from a bank. Or you could burn up the entire line-of-credit on a bank credit card, or you could just borrow money from your 401(k) plan.

In fact, most 401(k) plans do allow employees to borrow money from their accounts. The rules vary from employer to employer. Generally speaking, you can borrow up to half of your vested balance in the account—to a maximum of $50,000.

You can't withdraw money from your 401(k) before age 59 1/2 without paying taxes on the money withdrawn and paying a penalty, as well. But you can borrow money from your 401(k) at any age, without having to worry about a penalty.

A Few Words About Vesting

The vested balance is how much of the money in the plan is yours to keep and take with you should you leave the company and move your 401(k) account somewhere else.

The money you put into the plan is always yours—starting the day you contribute it. Matching employer contributions to your retirement savings plan don't become your property immediately. Vesting only occurs after a certain number of years of participation in a retirement savings plan. Here are the current rules on vesting:

•  Cliff vesting—whereby your employer's entire contribution vests all at once. This now occurs after three years on the job.

•  Graduated vesting—whereby part of the employer contribution becomes your property each year. This now must be completed after six years on the job.

How Borrowing From Your 401(k) Works

The rules here are pretty straightforward—as they should be. After all, what you are borrowing is your money. You can ask your company for specifics about tapping into your 401(k), but there shouldn't be any big obstacles.

Nor is it a rarity these days to have someone borrow money from their 401(k), rather than turn to another source. One recent estimate was that nearly 20 percent of all 401(k) participants have borrowed from their accounts.

The rules vary from plan to plan, but these are pretty standard:

•  Expect to pay the prime lending rate that banks are charging their best customers, plus an extra one or two percentage points.

•  Expect to have to repay the loan within five years (most of the time).

•  If the loan is to help you buy a home, you usually can stretch the repayment over a longer period.

The Arguments for Borrowing From Your 401(k)

Here are some of the best reasons for borrowing from your 401(k) when you need money:

•  You don't have to worry about a credit check. Loans from 401(k) accounts don't require them.

•  You don't have to go through a long application process. You may be able to get the money with just a phone call.

•  You'll pay a lower interest rate on a 401(k) loan than on most bank loans.

•  Repayment is easy. Most plans require that loan payments come directly out of your paycheck.

•  You are borrowing from yourself, so the interest actually goes directly to your plan. Instead of draining money away, as is the case with the interest payments on most loans, these interest payments add to the balance in your 401(k) plan.

•  Whatever interest you pay on the loan remains tax-sheltered until you finally begin withdrawing money from the 401(k).

The Arguments Against Borrowing From Your 401(k)

Just because it is easy to borrow from your 401(k) plan doesn't mean it is always a great idea to do so. Here are some reasons why you shouldn't.

•  It only looks like a loan. You really are spending your own money by borrowing from yourself.

•  You are probably losing income on the borrowed money. You are paying yourself interest on the loan so taking money out of the plan doesn't bring your return to zero. If you had your 401(k) invested in a money market fund, the interest on the loan might exceed the interest you were earning in the plan. But if you had the money invested in stocks, you have surrendered the chance of an average return of around 8 percent a year for a return that is likely to be far less than that.

•  You have up to five years to repay the money if you stay in the plan. But if you change jobs, or lose your job within those five years, the loan is due immediately.

•  If you can't repay the loan, it is considered a withdrawal from the plan. Unless you are at least 59 1/2, that means taxes and penalties.

•  Once saved, money must be allowed to accumulate in retirement plans over the years if you are to achieve a secure retirement. Taking money out of your nest egg during those years is just the opposite of what you know you must do.

Summing Up Borrowing From Your 401(k)

If you have a financial emergency and you absolutely can't find other sources for the money you need, consider your 401(k). However, make a rigid plan for repaying the loan and stick to it.

If you can possibly find another source for the money, do so. Spend your rainy-day fund—that's what it's there for. If you have extra cash sitting in a money market fund or a CD, use that.

If you must borrow to make the down payment on a home, maybe you are buying too costly of a house for your financial circumstances. Rethink your plans and see if there isn't some place a little less expensive. If you own a home and need spending money, consider a home equity loan.

If you own a home and need spending money, consider a home equity loan over a loan from your 401(k). The interest rate will probably compare pretty favorably with the rate on a loan from your 401(k) plan. Furthermore, the interest on a home equity loan is tax deductible, while the interest on a loan from your 401(k) plan is not.