Monday Money Tip: Borrowing against your 401(k) not always a good idea

If you need a loan, your 401(k) might seem like the perfect emergency fund. But financial planners advise exhausting all other sources before taking money out of your retirement fund.

The pros and cons of 401(k) loans boil down to one fact - it's easy.

"It's actually too easy," says Kathleen Connelly, executive vice president of client services at retirement-plan and record-keeping firm Ascensus in Dresher.

Pros:

You make interest payments to your own account when you repay the loan.

Loans are convenient and don't require a credit check.

You can borrow up to the lesser of 50 percent of your vested account value or $50,000.

"You're paying yourself back, rather than a bank," Connelly adds.

Cons:

The money you borrow isn't invested in the markets while the loan is outstanding. You repay the loan with after-tax dollars, subject to double taxation (once when repaid and again when distributed).

The loan may need to be repaid within 60 days if you leave or lose your job - otherwise, it's considered a taxable distribution and may be subject to penalties.

"Employers make it far too easy, and some allow more than one loan at any time," Connelly said. "Our view is that's not great retirement policy."

A $20,000 loan from your 401(k) over five years costs you $40,000 in long-term retirement dollars, she estimated. "Often these borrowers are taking money out for a new powerboat or a car."

During the holidays and tax-filing season, savers also draw heavily on their 401(k) to pay the bill.

"With credit tightening and home equity disappearing, working families are being forced to look to their 401(k) for access to capital. But taking a loan from your 401(k) can be harmful," said Mark Fried, president of TFG Wealth Management, in Newtown, Bucks County. "If you default, the loan is immediately reclassified as a distribution. You may owe taxes on the full outstanding amount plus a penalty."

If you leave your job by choice - or get fired - you will have to scramble to pay back your loan in 60 days. There are exceptions: If you withdraw 401(k) funds, you don't pay the 10 percent penalty if you've been laid off during the year you turn 55 or after. Fund administrators have to fill in form 1099-R box 7 with a code "2" (exception allowed).

Fried's advice to anyone considering taking a 401(k) loan: Exhaust all other possibilities.

646-797-0759