Borrowing Against a 401k: Proceed at Your Own Risk

Time is money, so removing funds from a retirement account can stunt your nest egg's growth. Photo:TaxCredits.net

It happens to many of us at some time or other: You're minding your business, going about your productive daily life, and then pow! -- a financial crisis rears its ugly head. Maybe you suddenly have to replace the transmission in your car, or a medical condition comes with steep out-of-pocket healthcare costs. Or maybe you just want to remodel your kitchen but don't have the funds. In such a situation, you might decide that instead of borrowing from a loved one or the bank, you should borrow against your 401k. If so, think again -- and again -- because borrowing against a 401k is rarely a good idea.

Why borrowing against a 401k is not recommended

What's so wrong with tapping into your own account? After all, you may well have more than you currently need just sitting there in your workplace 401k account, seemingly doing nothing. Well, know that you'll be on the hook to repay whatever you borrow. If you ultimately can't, the IRS will classify that 401k loan as an early withdrawal. You'll likely face income taxes on the outstanding balance of the loan, plus an 10% early-withdrawal penalty if you're younger than 59-1/2.

Borrowing against a 401k can leave you less able to jump at opportunities. (Image: Vectorportal, via Wikimedia Commons.)

Meanwhile, if you terminate that job, you'll likely be expected to repay the loan in full when you do so. So, if a more exciting job comes along, in order to take it you'll need to repay that loan in full or face taxes and penalties. Thus taking a 401k loan can limit your possibilities.

However, the main reason borrowing against a 401k is a bad idea is this: You lose a lot of money. For starters, whatever you withdraw from the account will be taking a vacation from growing for you. Those funds are in the account with the sole purpose of growing over the years so that you can amass a nest egg to see you through retirement. You'll be setting your progress back many steps by removing part of that growing nest egg. Further, many plans have terms that prohibit you from making new contributions to your account until the loan is paid off, which sets you back even further.

Imagine that you withdraw $10,000 from your 401k and pay it back in five years. If it had stayed in your account, invested in the stock market and earning 10% annually on average, then it would have grown to about $16,000. So you would lose out on $6,000 of growth. And in the following years, that $16,000 would have kept growing -- but instead, you'll be starting that post-loan growth period with $10,000 plus some interest. Borrowing from retirement funds can really put a crimp in your comfy retirement.

A big, long-term loan can really whack your retirement account. Photo: TaxRebate.org.uk. via Flickr.

Is there any upside?

Is there any circumstance in which it might be OK to borrow from a 401k? Yes, if you truly have no other reasonable option and you need the money -- e.g., for medical expenses, not a new convection oven and an island for your kitchen. Advocates of 401k loans like the interest rates, which are often lower than what you'll get from a bank or other commercial lender.

It can also make sense if you're borrowing for a period that will definitely stay short-term. That will be less damaging to your retirement than a long-term or open-ended loan. If you're pretty certain that you won't be losing or changing your job anytime soon, that's a plus, too.

There's no one-size-fits-all answer to the question of whether you should borrow against your 401k. Whatever your circumstances may be, make sure you recognize the full impact on your retirement savings.

The article Borrowing Against a 401k: Proceed at Your Own Risk originally appeared on Fool.com.

Selena Maranjian has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.