If you participate in a 401(k) or 403(b) retirement plan through your employer, chances are good that you have the option borrow money from your plan.

How 401(k) or 403(b) retirement plan loans work:

  • Once your balance reaches a certain dollar amount, you may be eligible for a loan
  • When you apply for a retirement plan loan, the administrator spots you the cash
  • A portion of your retirement plan money is held aside as collateral until you pay the loan back
  • Once you pay back the loan amount, the money held for collateral is made available to you again

Considering a loan from your retirement plan? Ask your HR department for details. Each retirement plan can set the guidelines for loans, within certain limits set by the government. Some plans have pretty flexible loan provisions, while others are more rigid. Some plans only allow loans after your balance reaches a certain level, or no loans at all.

Advantages of 401(k) and 403(b) loans:

  • Your credit score isn’t a factor since you’re basically borrowing from yourself.
  • The application process is usually relatively simple and can often be done online or by phone.
  • Interest rates are generally pretty low as compared to other types of loans, such as credit cards.
  • Loan payments can be made by payroll deduction.

Drawbacks to 401(k) and 403(b) loans:

  • The amount of your retirement plan used for collateral can’t be invested in the market.
  • You may suffer penalties if you are unable to pay back the loan.

No wonder retirement plan loans look so attractive. Just look how the advantages appear to outweigh the drawbacks. In a perfect world, it’s a no brainer: a 401(k) and 403(b) loan is far better than many other kinds of loans. The reality is, we don’t live in a perfect world. If we did, we wouldn’t need loans in the first place.

Here’s how a 401(k) or 403(b) retirement plan loan can wreck your retirement

So far, we’ve only looked at what happens if things work out as planned. However, there’s a big BUT to this story and it’s this: If your job ends before your pay the loan back, that amount (and more) comes out of your retirement savings. Let’s look at a scenario.

Example of how a 401(k) plan retirement loan can go wrong

Jimmy has $30,000 in his 401(k) retirement account. He has $10,000 in credit card debt and medical bills that are causing a strain on his monthly budget.

He checks into a 401(k) loan and realizes he can pay about $100 less a month in loan repayments if he borrows $10,000 to pay off his other debt. So, he takes out a 401(k) loan that he plans to pay off over the next three years.

Six months later, management reorganizes his department and eliminates his position. Now, Jimmy is in a dilemma. If he doesn’t pay back his $9,000 loan balance right away (within 90 days), the money will be taken out of his retirement savings to repay it.

To make matters worse, he’ll have to pay income taxes on the $9,000 since it’s considered a distribution from his retirement account. And because Jimmy isn’t of retirement age yet, he’ll also have to pay a 10% premature withdrawal penalty.

The end result is that, through no fault of his own, Jimmy’s retirement savings have just been reduced by about 40% ($9,000 + $2,250 in taxes + $900 penalty = 12,150). So, instead of $30,000 in retirement savings, he walks away with only $17,850. To add insult to injury, he also needs to go find a new job.

Has this happened to someone you know? Tell us about it in the comments section.

The scenario above is very real and happens all too often, although the numbers are different for other individuals. I know several people who have paid these exact consequences for a short-sighted decision. In the example above, the reason for termination was a reorg. But, it can happen to you for a different reason, such as corporate “right sizing” (i.e. layoff). Or maybe you’re offered a better job for a different employer and change jobs for a positive reason.

Whatever the case, if you take a loan from your retirement account and aren’t able to pay it back shortly after you leave that employer, it could cost you big time.

When is it okay to take a loan from your 401(k) or 403(b) retirement plan?

My recommendation to anyone considering taking a loan from your retirement account is this: Only do it if you are 100% certain you can repay the loan before you leave your employer.

For instance, if you know you have a tax refund or other cash settlement coming soon and you absolutely have to pay another debt before a looming deadline, I’d say it’s okay to float a 401(k) loan for a few months.

What about a loan for future expenses?

The only way I would agree with someone’s decision to take out a retirement plan loan to pay for future expenses (such as a home remodel, vacation, wedding or other bills) would be if you are now or will soon be of retirement age (generally 59-1/2) and can get a significant discount for paying the expense up front.

The takeaway

A low interest rate loan from your employer’s 401(k) or 403(b) retirement plan may sound like a good deal on the surface. However, it can cause you to lose a good chunk of your retirement savings if you are unable to repay the loan before you retire.

If you’re considering a retirement plan loan, proceed cautiously and look at all the possible outcomes before making a decision. Already took the loan? Don’t give your boss any reason to fire you and pay it back as quickly as possible.

Questions or comments? Sound off in the comments box.

This post is intended to be educational only. It should not be construed as investment advice or instructions on what to do with your money.