The 401k plan is one of the greatest financial instruments ever created. Not only are people able to earn compounded interest on pre-tax dollars, but they can actually loan that money to themselves should the need arise. While the ability to loan money to yourself may have some benefits, it comes with some significant risks.

How to Borrow from Your Retirement Plan

When you borrow from your own retirement savings, you are making a loan to yourself. You will still have to pay interest on that loan. If you fail to pay back the principal, you will owe income tax on the loan plus a 10% early withdrawal penalty. Most plans allow you to pay back the loan on a 5 year amortization with no prepayment penalty. Ideally, one can set up automatic withdrawals to ensure that the loan is paid off with regular payments. Another idea is to have your employer direct a portion of your pay check to this account via direct deposit. Each 401k plan has rules regarding loans and you should consult your plan administrator if you are considering this option.

Advantages of Borrowing From Your 401k Plan

Instant approval. There is no loan application, no credit check, and the loan won’t even be reported to a credit bureau.
Flexibility. You can repay the loan on your own terms without having to consider minimum payments or penalties for prepayment or late payments.
Minimal fees. Unlike most other loans, you will not have to pay huge fees to borrow from your 401k plan. There may be an origination charge.
Interest is paid to yourself. Even if you were to receive a low interest rate from a third party, they would still retain the interest. When you loan money to yourself, you are both the lender and the borrower. Any interest you pay will go back to your own account.
Drawbacks of Borrowing From Your 401k Plan

You stop saving money. By borrowing money from yourself, you are no longer saving money for retirement, you are merely trying to get back to where you started.
You are not earning tax free interest. Yes, you are paying yourself interest, but your are doing so from your after tax income. If you had not taken the loan, you would still be earning a return on your pre-tax savings and your continuing contributions.
You are taking a risk with your retirement. The reason you need a loan is because of serious shortage of funds. Given your present circumstance, it is even more likely that you will have a similar problem when it comes time to paying yourself back. Failing to do so will severely set back your retirement savings.
When It Can Make Sense To Borrow From Your 401k

While it almost always a bad idea to borrow from your 401k plan, it is possible to construct a scenario where this option might make sense. If any of the following conditions apply to your situation, borrowing from your 401k may be worth considering.

You need a short term loan. The quicker you pay back your loan, the less damage you will due to your retirement savings.
You have an extremely serious need. No one should ever consider borrowing from their 401k to fund anything other than their most urgent expenses.
You are unable to obtain a loan from any other source. You should exhaust all other potential sources of money before dipping into your 401k, even if it is only a loan.

The ability to borrow from your 401k is kind of like an accident insurance policy that covers dismemberment; it is an obscure benefit that few ever use and that you hope you will never need. That said, you can file this option deep in the back of your mind, just in case you have no other alternatives. Your retirement plan exists for only one reason, to ensure your future financial security. To ensure that it will be there when you need it, do not make the mistake of taking out a loan for anything short of the most dire circumstance.

Jason D. Steele is personal finance writer and a consumer advocate. He specializes in helping people eliminate credit card debt and maximize rewards. His work can be found at personal finance sites like Wise Bread, Ask Mr Credit Card, and at his home page.

Photo by Jussi via Flickr

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