Should I Tap My 401(k)?

By: Jonathan D. Pond | Source: AARP.org | July 28, 2009

Is it possible to use my 401(k) plan to get a loan? –Shirley, California

A loan from your 401(k) plan is an easy way to get necessary cash. This can come in handy if you are having difficulty borrowing money from other sources.

But don't take borrowing from your retirement nest egg lightly. After all, you're borrowing against your future retirement. If you can't pay it back, you'll incur taxes, penalties, and a lower retirement income. If you're going to get a 401(k) loan, it really should be for a very good reason—and almost as a last resort.

Loan Rules
While federal law imposes no restrictions on how you can use the money, the plan administrator can limit loans for specific purposes. In fact, the first thing to do is to check with the plan administrator to see whether or not loans are permitted. If so, find out the permissible reasons to take out a loan. These typically include paying college tuition, funding a down payment on a home for first-time buyers, and  hardship reasons, such as paying your mortgage in order to prevent foreclosure and paying un-reimbursed medical expenses.

Repayment Rules
The rules on repaying the loan are also established by the plan administrator. Typical 401(k) loan rules may include the following provisions:

• Length of Loan: Most often, the loan term is five years or less. In the case of a home loan, terms could be as long as 15 years.
• Loan Maximum: Usually the lesser of 50 percent of the account balance or $50,000.
• Loan Fees: Most 401(k) plans can charge fees for loans, including loan-initiation fees and annual service charges.
• Repayment: This typically occurs evenly over the loan period and is often accomplished by payroll deduction.

Here are the major advantages of 401(k) loans:

Applying for the loan and receiving the funds are both easier and quicker compared with borrowing money from a traditional lender. There is no credit check.

The loan interest rate is lower than other loans, which it should be, since you're borrowing your own money. While many think it is particularly advantageous to borrow from a 401(k) because the borrower pays back interest to himself or herself, keep in mind that the borrower is taxed twice on the interest paid. First, you would pay the interest with after-tax dollars, and second, when you eventually withdrew that money in retirement, you'd be taxed on it again. While that's still better than paying interest to a lender, paying interest to yourself is not as great a deal as many people believe.

Here are some of the potential problems associated with 401(k) loans:

If you were to lose your job or move to another employer, you'd typically have 30 to 90 days to pay off the loan, depending on the plan's rules. If you couldn't pay the loan in time, you'd be subject to taxes, and, if you're under age 59½, a penalty.

If you stop making contributions to help yourself repay the loan, you not only risk further impairing your retirement nest egg, but you lose out on the income tax savings associated with 401(k) contributions. If your employer still matches, you would also lose that contribution.

So a 401(k) loan can come in handy if you really need the money and know you'll be able to pay back the money you borrow. Otherwise, I would steer clear.

At what age do distributions from 401(k) plans have to begin? –Mary, Illinois

The rules for distributions from 401(k) and other workplace retirement plans are the same as for IRAs, with one big exception. But first, here are the basic rules.

Generally, each plan participant must begin receiving at least the "required minimum distribution" (RMD) no later than April 1 of the year following the calendar year he or she reaches age 70 ½, just as with IRA accounts. The date on which the investor turns 70 ½ is known as the "required beginning date" (RBD). Subsequent RMD amounts must be distributed by Dec. 31 of each year. The plan administrator must figure the RMD for each participant and distribute the amount to each participant, who is required to withdraw an RMD from his or her plan account. 

The Exception
The exception to the rules pertains to employees who are still employed after reaching age 70 ½. If the plan allows it, and the employee is still employed after he or she reaches age 70 ½, the RBD could be delayed until April 1 following the year the employee retires. The option to delay the RBD is not available to employees who own at least 5 percent of the business.

One more point: Whether you are already making RMDs or are scheduled to make one this year, the requirement to make a distribution has been waived for 2009.

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