When is it OK to borrow from your 401(k)?

There are plenty of horror stories about people who borrow from their retirement plans -- the teacher who took a small distribution and forgot to pay it back until it ballooned to 10 times the original loan, for example, or the unemployed worker who ended up with a massive tax hit because he was unable to repay the loan within months of losing his job.

But borrowing from a 401(k) isn't always a bad idea. For those with the right jobs and circumstances, borrowing from your company's retirement plan may actually be smart, said Christine Benz, director of personal finance at Morningstar in Chicago.

"Many people are allergic to the idea of borrowing from their retirement plans, but when you look at the math, a 401k loan can sometimes add up to the right answer," she said.

So when is it OK to borrow from a 401(k)?

First, it's important to understand that all 401(k) loans are not alike. Although federal tax rules allow 401(k) loans of up to half the account balance or $50,000 (whichever is less), whether any given plan allows borrowing and the terms of those loans depends on the employer and the plan.

These self-directed retirement plans are a voluntary benefit provided by employers, and aside from setting some restrictions on how much can be contributed, and barring discrimination against any individual or group of participants, the government lets employers set the rules.

Thus, some companies make 401(k) loans readily available, while others only people to borrow only in dire circumstances. The borrowing, including the interest you pay, how fast you must repay and what happens if you lose your job when you've got a loan outstanding, also vary. That makes it pivotal to dig into the terms of the loan agreements before participants even consider borrowing from the plan.

It's worth mentioning that the biggest problems in borrowing from a 401(k) all involve participants having trouble paying back a loan. If your company's plan requires the loan to be repaid immediately if you left your job, the loan could put you at great economic risk. Why? Because if you can't repay a 401(k) loan as per the terms, the loan could be converted to a "distribution." Prior to retirement age, distributions from a retirement plan are not only taxable, they're also subject to tax penalties. That can cause the participant to lose half of their borrowed savings to income taxes, which translates into an extremely high-cost loan.

That said, if the employer's plan has some repayment flexibility even in the event of a termination, the other terms on plan loans are often attractive. Most notably, borrowers usually pay back the interest, minus a small administrative fee, to themselves. Thus, if the plan charges 3.5 percentage points on loans, maintaining 0.5 percentage points as an administrative fee, the remaining 3 percent becomes your investment return on the borrowed amount.

Payments usually are made through payroll deductions, just like contributions. And though you don't get a second tax deduction for making payments on the loan, the loan proceeds aren't taxable, either. So it can be a cheap way to borrow.

The caveat: Aside from the interest that you're paying yourself, the funds you borrowed away are not earning investment returns. If the loan remains outstanding during a bull market, you could have a significant lost opportunity. On the other hand, if you borrow before a market plunge, you also avoid market losses on that portion of your portfolio.

Given those risks, it does not make sense to borrow against a plan for day-to-day expenses, or even extraordinary costs that could be financed another way. If you owe the IRS back taxes, for instance, it's smarter to set up a payment plan. If you want to buy a house or car, you're usually better off with a traditional loan.

However, if you had incurred significant high-cost credit card debt due to a medical or personal emergency, using a 401(k) loan to repay that debt might make sense, Benz said. It could lower the interest cost on the debt; make the payments more affordable; and save any potential penalties that could be due for late or missed payments, since you'd be making payments on the 401(k) loan automatically from your paycheck.

It can also make sense to borrow against a plan for a short-term loan that you know you can pay back promptly. If you have arranged long-term financing for an important transaction, such as the purchase of a business or real estate, for example, but need a so-called "bridge" loan to complete the deal, a 401(k) loan could provide the needed money and be repaid with the long-term loan.

The final time a 401(k) loan makes sense is when you are cash poor, but know you have more in retirement savings than you're ever going to need. This might happen when you have been contributing prodigiously to a plan for the several decades since you started working, but had no other savings. In this instance, you could borrow the maximum allowed from the plan and stop making new 401(k) contributions while you repaid the loan. That would slow the growth of your retirement plan, while allowing you to build assets elsewhere.

Assuming the borrowed money is invested at a comparable return to the retirement money, the only cost of this borrowing comes from taxes. Income and capital gains earned on money invested outside of retirement plans is subject to income taxes. However, if the money is passively invested in, say, an index fund, the taxable income would likely boil down to annual dividend payments that might amount to 2 percent or 3 percent of the amount invested.

That's a reasonable cost for someone who needs the economic flexibility and is certain to have both sufficient retirement income as well as the ability to pay off the loan at a moment's notice (possibly from the taxable account proceeds), if necessary.

How would you know if you had far more than you'd need for retirement? A number of web calculators can help you figure how much you'll need. Among the best of the lot is the Retirement Savings calculator at Kiplinger.com.

A word to the wise, however. Retirement calculations hinge on a number of factors, including what percentage of your working income you think you'll need, the rate of return you expect to earn on your money and when you think you'll retire. It's smart to do multiple projections, making multiple different assumptions, to make sure that you don't borrow away money that you'll need later. It's wise to update the projections on an annual basis, too.

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