If you are like the many working Americans, your employer offers a defined contribution retirement plan, such as a 401(k) or 403(b), which allows you to defer amounts from your salary for future retirement savings. Many of these plans offer loan provisions which allow employees to borrow back their own contributed dollars should such the need arise. But what are the consequences of taking such plan loans and is it ever a good idea?

In the retirement plan industry, the larger an employer’s aggregate plan size, typically the lower the overall costs.  So employers and plan participants benefit by having larger plans and increasing the participation rate increase within the plan.  In order to spur investment, a loan provision offers a line out in case of emergency or hardship because, after all, people are a lot more willing to put money in if they can take it out again.

While taking a plan loan generally comes with fewer immediate consequences than a withdrawal, there are specific pitfalls in borrowing against your retirement.

• Loans do avoid income taxes and penalties, and the interest paid goes back to the employee.  But even the best-intentioned loans will directly impact your future retirement savings.  Taking out a loan against your 401(k) involves a commitment to a repayment schedule over a set number of years.  So during these repayment years, the money you contribute to your 401(k) goes towards paying back a debt instead of building a bigger nest egg.
• Maybe your loan is relatively small and you can pay it off in the allotted time.  But what happens if you find another job during this repayment period, you decide to retire, or experience a layoff?  In that case, you no longer have a loan–you have a withdrawal for the outstanding loan balance.  That means you potentially will owe income taxes, and if you are under age 59 ½ you have to tack on a 10% penalty.

Whether a loan is justifiable or not tends to be subjective.  For some, perhaps taking a loan from a 401(k) for education costs or a down payment on a home makes sense.  But often, material purchases like a new car or kitchen can seem like great ideas at the time, too.  Before considering a plan loan, consider your likelihood of repaying it, whether your intention for the funds is for a necessity (or not), and whether you understand the impact on your long-term savings.  You should always consult with your tax preparer prior to taking any withdrawals, and be sure to consult with your plan administrator or review your plan’s Summary Plan Description (SPD) for the specifics of your company’s retirement plan.

Basic facts about 401(k) plan loans:

• IRS maximum limits permit you to borrow the greater of 50% of your employee salary deferrals or $50,000—whichever is greater.  Some plans have stricter limits.
• Unrepaid loan balances become withdrawals—with all of the tax implications and associated penalties.
• Loans have to be repaid at interest with a set repayment schedule, though the interest goes back to the employee’s plan balance.