A 401(k) loan might make sense, but it should only be your last resort

A loan against your retirement nest egg might not always be a terrible idea—but it usually is.

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Employer-sponsored 401(k) retirement plans were never expected to become the primary retirement tool of American workers, but the 401(k) has largely displaced pensions as the go-to vehicle to meet your retirement goals. According to data from the American Benefits Council, in 2010 there were nearly 639,000 total plans, 88.7 million participants, and some $3.8 trillion in assets tied up in 401(k) plans.

Unfortunately, as the importance of the 401(k) has grown, so has the temptation among workers to borrow against their plans. In 2011, according to statistics from the Internal Revenue Service, $5.7 billion in early withdrawal penalties were collected, meaning some $57 billion in retirement funds were withdrawn before consumers were eligible to do so. As a quick refresher, you're only eligible to begin making withdrawals from your 401(k) once you reach age 59½, or if you have a qualified financial hardship, such as costs associated with a principal residence, medical care expenses, or funeral expenses.

Under the right circumstances, a 401(k) loan may not be a terrible idea; however, I would encourage workers considering such a move to utilize their employee-sponsored retirement nest eggs as a piggy bank of last resort.

When a 401(k) loan makes sense

If the situation is right, a 401(k) loan could work in your favor.

For instance, a 401(k) loan, which is most often structured as a 5-year repayment plan, can sometimes have substantially more attractive lending rates than what you'll find at a bank or credit union, or even from family and friends. If you have an average-to-poor credit score, your access to a loan, or a loan at a non-"arm-and-leg" interest rate, could be limited. A 401(k) loan typically is a few percentage points above the prime rate (currently 3.25%), and—best of all—the interest paid on the loan winds up going back in your pocket.

It's also worth noting that taking out a loan against your 401(k) won't hurt (or help) your credit score. If you fail to make your payments, you'll simply be required to pay taxes and possible early withdrawal penalties on the money you've taken out. Again, it's a potentially smart move for an individual with a low credit score who otherwise may not be able to get a loan.

If you have an eligible reason, it could be worth borrowing from your 401(k), too. This doesn't mean you want to buy the latest car to impress your friends. Instead, it means putting a down payment on a new home—since you can't borrow from an IRA, using a loan from a 401(k) is a cash-ready option—or potentially paying off an unexpected medical bill.

And, of course, if you've exhausted every resource available—a home equity line of credit, personal loan, or even a loan from a friend or family member—then a 401(k) loan might be the appropriate path to take.

...but a 401(k) loan comes with a potentially hefty price

However, investors need to understand that a 401(k) loan comes with a potentially hefty price tag attached.

First and foremost, borrowing money from your account denies that money the chance to compound over time. A low lending rate might be preferable when paying back a 401(k) loan to yourself, but money invested in the stock market historically earns about 8% per year. Chances are, the longer the money is out of your account as a loan, the more compounding power you'll lose.

It's also worth noting that taking a loan out against your 401(k) is going to expose you to the dreaded "double-taxation." Money that's used to repay a 401(k) is after-tax dollars, and the money pulled out at retirement is also after-tax dollars. In the end, even after repaying your loan, you'll likely wind up with less in retirement than if you had never taken out a 401(k) loan in the first place.

A 401(k) loan may not adversely affect your credit score, but it does come with risks that you may not be aware of. For example, failure to pay back the loan within the specified timeframe (usually 5 years) will trigger an early withdrawal penalty of 10% if you're under the age of 59½ and subject the withdrawal to ordinary income taxes, and could exclude you from contributing to your employer-sponsored 401(k) in the future. It's actually not uncommon to be denied the ability to contribute to a 401(k) as long as you have an outstanding loan against your plan, further hampering your ability to save and allow time and compounding to do their work.

Additionally, if you lose or quit your job, your 401(k) loan often needs to be paid back in an accelerated fashion, within 60 or 90 days. If you don't, you'll be exposed to income taxes and possible early withdrawal penalties. If you don't have rock-solid job security, then taking out a 401(k) loan is typically an unwise move.

Lastly, you'll need to understand that your take-home pay will be reduced because of your regular monthly repayment. Pulling out quick and easy cash to cover a debt might seem like the right move this very moment, but when your other bills keep rolling in months from now, your earning power will be reduced by your 401(k) repayment.

Ultimately, consumers need to carefully weigh the immediate benefits of a 401(k) loan against its possible long-term implications. I'd be willing to bet that borrowing against your 401(k) is most often a poor idea, but as I said above, under certain circumstances taking a 401(k) loan could be a reasonable option.

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Article copyright 10/4/2015 by The Motley Fool.
The statements and opinions expressed in this article are those of the author. Neither Fidelity Investments nor your employer can guarantee the accuracy or completeness of any statements or data.
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