Don't Go Holiday Shopping With Your 401(k)

When you're shopping for the holidays, it can be tempting to abandon your budget and buy more than you planned for your family and friends—or for yourself. But what happens when the credit card bills start coming in? Or you realize that you don't have enough cash to cover your everyday costs?

If you find yourself thinking about tapping your 401(k) for extra funds, you may want to think again. A 401(k) is where many Americans build their retirement nest egg, and that of course is the primary function of a 401(k) account. But some 401(k) plans allow participants to take out loans. While taking a loan may help solve an immediate financial need, there can be consequences that may reduce your long-term financial security. Here's what you should know before taking a loan from your 401(k).

401(k) Loan Basics

First, not all 401(k)s permit you to take out a loan. Check with your company's Human Resources office to find out what is possible. When you borrow from your 401(k), it's like getting a loan from any financial institution. You sign a loan agreement that spells out the principal, the terms of the loan, the interest rate, any fees and other conditions that may apply. You may have to wait for the loan to be approved, though in most cases you'll qualify. After all, you're borrowing your own money. And, when it comes to making good on your loan payments, most 401(k) plans require you to repay your loan through payroll deductions, which means you're unlikely to fall behind as long as you remain employed.

The IRS limits the maximum amount you can borrow with a 401(k) loan at the lesser of $50,000 or half the amount you have vested in the plan. In some plans you must borrow at least a minimum amount of money, which is called the "loan floor."

And you must pay a market interest rate. This means the rate must be comparable to what a conventional lender, like a bank, would charge on a similar-sized personal loan.

401(k) loans typically have a five-year term. That's the longest repayment period the government allows. However, you may be able to arrange a shorter-term loan if that's what you prefer. The only exception is if you use the loan proceeds to buy a primary residence—the home you'll be living in full time. In that case, some 401(k) plans allow a 25-year loan term.

So what happens to your 401(k) investments when you take out a loan? The money usually comes out of your account balance. In many plans, the money is taken in equal portions from each of the different investments in your account. For instance, if you have money in four mutual funds, 25 percent of the loan total comes from each of the funds.

Some 401(k) plans permit you to designate which investments you'd prefer to tap to put together the total loan amount.

Pros and Cons of 401(k) Loans

Before you borrow from your 401(k), consider the following.

On the plus side:

  • You usually don't have to explain why you need the money or how you intend to spend it.
  • The interest you pay is paid into your 401(k).
  • There is no income tax or potential early withdrawal penalty, since you're borrowing rather than withdrawing the money.

On the negative side:

  • The money you withdraw will not grow if it's not invested.
  • You repay the loan with after-tax dollars that will be taxed again when you eventually withdraw them from your 401(k), so you are paying double taxes to get the benefit of the loan funds.
  • The fees you pay to arrange the loan may be higher than on a conventional loan.
  • The interest on the loan is not deductible, even if you use the money to buy or renovate your home.

Beware of the Risks

The biggest risks you likely face with a 401(k) loan is leaving your job or getting laid off or fired while you have an outstanding loan balance. If that's the case, you'll probably have to repay the entire balance within 90 days of leaving. If you don't repay it, you'll be in default, and the remaining loan balance is considered a withdrawal. You'll also owe income tax on the full amount. So you could find your retirement savings substantially drained and your long-term financial goals in jeopardy.

For more information on managing and investing in a 401(k) account, visit FINRA's 401(k) Learning Center.