Is borrowing from my 401(k) a good idea?

DK asks:

What do you think about taking a loan against my 401(k) (which is performing abysmally)? My 401(k) plan does allow me to take out a loan, and because I have to pay the interest to myself (around 10%) it seems like a way to indirectly "up" the amount that I am contributing to the plan. Your thoughts?

Even though approximately 85% of 401(k) plans allow participants to take out loans, borrowing from your 401(k) is generally considered to be a bad idea and a "last-resort" measure. Too many people view their 401(k) as a bank and don't have the discipline (or the ability) to pay back the loans. Also, when you take a loan from your plan, you are giving up years of tax deferred compounding on the amount withdrawn. And even though borrowing from your account is relatively easy to do, there are risks involved. If you should lose your job while you have a loan outstanding, you would need to pay it back quickly. Most plans require you to pay back the entire loan within 60 to 90 days. If you cannot repay the loans, the unpaid balance is treated as an early distribution subject to ordinary income taxes and a 10% penalty if you are under age 591/2.

However, there are very limited circumstances where borrowing from your 401(k) can result in a slightly higher account balance at retirement. The scenario you are describing, where the interest rate paid on the loan is significantly higher than the return earned on the account, is one of them. Standard and Poors has a really great calculator that shows the impact of a loan on the terminal value of your 401(k) -- look for the "Borrowing from your 401(k)" topic. I suggest you enter your specific information and see how the loan impacts the final value of your account. Before trying the calculator, I suggest double-checking the interest rate you were quoted. Most plans set loan rates at a percent or two above the prime rate. Your 10% rate seems pretty high and it might be skewing the analysis.

However, even if the calculator indicates a marginally higher ending account balance, I just really don't like the idea of borrowing from the 401(k). I think it sets a dangerous precedent. Sure, the market has not been performing well lately, and (at the moment at least) the interest that you are paying yourself on the loan might be higher than the return in the 401(k), but you need to keep your focus on the long term picture. When you focus on the long term, I think it would be difficult to consistently beat the return of a well diversified, equities-based retirement portfolio. Also, you need to remember that the loan is going to be re-paid with post tax dollars.

Other important things to know about borrowing from your 401(k): some plans do not allow you to make contributions to the plan while the loan is outstanding. If this is the case with your plan, borrowing from the account is most likely a huge mistake. Remember that if no contributions are permitted, you would also be losing the employer match. Also, loans used for any other purpose besides a new home purchase, must be repaid within 5 years. In addition, there are limits to the amounts you can borrow -- total loans outstanding cannot exceed the lesser of $50,000 or half of the present value of the account (subject to a $10K minimum). Also, there must be bona fide reason to borrow. If the transaction does not create a debtor/creditor relationship the amount transferred could be treated as a plan distribution. Finally, some plans restrict borrowing to certain circumstances like paying unexpected medical expenses, etc. Check with your benefits department for more details.