Borrowing From 401(k) Should Be a Last Resort

CASH-STRAPPED CONSUMERS are developing a bad habit: using their retirement savings to tackle everything from credit-card debt and late mortgage payments to income tax bills.

In 2007, 18% of employees reported taking out a loan from their 401(k) or 403(b) (the employer-funded equivalent for public educators and nonprofit employees), up from 11% in 2006, according to the Transamerica Center for Retirement Studies, a nonprofit. Of those borrowing, 49% said they needed the money to pay off debts, nearly twice the number that previously cited that reason. Major employer-sponsored retirement plan providers, including Fidelity Investments, J.P. Morgan Chase and T. Rowe Price Group, have reported similar trends. The average outstanding loan balance: $7,292.

"Consumers are dipping into their 401(k) accounts because they don't have any other options," says Mark Nash, a partner at PricewaterhouseCoopers' Private Company Services Practice in Dallas, which advises clients on retirement issues. The credit crunch and slumping real estate market have limited homeowners' ability to secure home equity loans. Combine that with a national savings rate that has languished near zero percent since 2005 and consumers have few accessible liquid assets with which to handle a possible job loss, wage decrease or crippling debt.

In dire situations like these, borrowing from your 401(k) may seem like the best recourse; it is your money, after all. And instead of paying the plan provider interest, you're paying yourself interest. Borrowers can access up to $50,000 or half their balance, whichever is less, with minimal paperwork and no credit check. "It's almost a shoe-in as far as a loan goes," says Gerri Detweiler, credit advisor for Credit.com. Some companies have made it even easier to gain access to 401(k) cash. They're allowing employees to allocate part of their 401(k) balance to a high-yield money-market account, then providing them with a debit card that lets them withdraw those funds as a loan.

But borrowing from your 401(k) can do far more harm than good. "There's only one reason to prematurely dip into your 401(k) — you've got a loan-shark named Louie waiting outside your door with a baseball bat, waiting to break your kneecaps," says Patrick Astre, author of "This Is Not Your Parents' Retirement." Even then, it might not be your best bet.

Carefully consider these five reasons to leave your 401(k) or 403(b) intact:

The markets should recover

"We're in an environment where it's not a good time to be pulling money out of the market," says Brad Levin, a certified financial planner and president of Legacy Wealth Partners in Encino, Calif. "Prices are down, and they're going down." Depleting your balance hits harder — if you've seen your balance drop 6% since the beginning of this year (about the same amount that the Dow Jones Industrial Average has fallen), taking out a loan of $10,000 now would be the equivalent of borrowing more than $10,600 at the beginning of January. You'll also miss out on potential returns when the market comes back to life. "If the market turns around, you're limiting your returns to whatever your interest rate is," says Nash. "You've essentially put your 401(k) into a fixed-income investment." Depending on your company and plan provider, that might be as little as 5%.

Compound savings

Borrowing from a retirement savings account also means missing out on that money's ability to compound from now until retirement. "You're taking a giant step back from being able to retire," says Harry Wendroff, CPA and managing partner of Buchbinder Tunick & Company, LLC in New York. A 35-year-old man with a 401(k) balance of $25,000, for example, could save $757,409 for retirement by age 65 (assuming 8% annual returns, a contribution of 7% of his $50,000 salary and no company match). But if he took a $10,000 loan and repaid it over five years, he'd lose $25,892 of that amount. If he halted contributions while he was repaying the loan, the loss grows dramatically to $132,171.