A 401(k) loan can be a short-term cure
By Lucy Lazarony • Bankrate.com

Feeling weighted down by big credit card bills and considering a loan from that fat 401(k) account?

A 401(k) loan may be a short-term cure for debt, but think before you sign for one -- this is a loan that will require careful management for several years to come.

It's easy to do
About 75 percent of all 401(k) plans allow employees to borrow from their accounts, typically up to half of an employee's vested account balance, or a maximum of $50,000, according to the Profit Sharing/401(k) Council of America. Most plans that allow people to borrow require that they pay back loans within five years.

You pay yourself back at a low interest rate -- typically 1 percent or 2 percent above prime. Plus, there's no credit check and repaying the loan through payroll deductions is a snap.

The pitfalls
But experts agree: Proceed with caution and only use this option as an absolute last resort. Think of a 401(k) account as a safe haven rather than an emergency fund.

"We feel it's a very bad habit and we would avoid it at all costs," said Ben Baldwin, a certified financial planner in Northbrook, Ill. "We try to get people to hang on to their money for retirement."

The pitfalls to borrowing are plentiful. First, some companies charge fees including $200 to $400 application fees. And, unlike 401(k) contributions, loan repayments are yanked from paychecks after taxes, not before. The loan is taxed again at retirement when it is withdrawn with the rest of the money in the account.

"The government doesn't care. They don't even apologize." said Dee Lee, a certified financial planner and author of The Complete Idiot's Guide to 401(k) Plans.

Retirement may erode
And the more money borrowed from a 401(k) account, the less the investment can grow. Things get worse if people try to avoid double deductions from their paycheck by stopping regular 401(k) contributions while they're repaying the loan.

"You do that a couple of times during your working career and you can really sabotage your retirement," Lee said. "It's the difference between salmon and tuna fish."

And borrowers should consider their level of job security. A person with an outstanding 401(k) loan who leaves a job better be prepared to pay up -- fast. Most plans require the loan to be paid within 30 to 90 days.

If the loan is not repaid, it is considered a default and the outstanding loan balance is treated like an early withdrawal. It is taxed as ordinary income, and a 10 percent penalty is collected if the borrower is under the age of 59 ½.

Say a person had an outstanding balance of $1,000 when they were suddenly laid off. If they were in the 28 percent tax bracket they would owe $280 in federal taxes, plus any state taxes, plus $100 penalty for early withdrawal.

"You're only getting $620 out of $1,000 after taxes," said Howard Dvorkin, president of Consolidated Credit Counseling Services in Fort Lauderdale, Fla.

"That's almost 40 percent in taxes. That's huge. That's an expensive loan."

Penalties can be severe
And that's precisely why so many financial planners advise against the loans in the first place. The taxes and penalties that occur if a person fails to repay the loan are just too severe.

And, as Baldwin points out, owing money to a credit card company is one thing, owing money to the federal government is quite another.

"Uncle Sam's about the most impatient lender out there," Baldwin said. "I see a hole being dug."

That hole will seem especially deep if a person continues to charge away on their credit cards after paying them off with the 401(k) loan.

"When doing any kind of borrowing, people need to understand ... what got them in the hole in the first place," Lee said. "You've got to stop the cycle. Otherwise, it will go on forever."

Things to think about
Before borrowing from a 401(k), consider these questions:

• Is it practical to make loan payments and still make contributions to the 401(k) plan?
• Can credit card spending be curbed?
• Is the job secure?
• Can the loan be paid off on short notice if the job is lost? Is the risk of taxes and the early withdrawal penalty acceptable?
• Are there other ways of getting out of credit card debt? Is it possible to increase monthly payments or get a lower rate card rate? What about cashing in a mutual fund or a savings account?

As a general rule, you should avoid raiding your 401(k) except as a last resort.

-- Updated: July 8, 2004