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Dear Penny: I can get a 401(k) loan and pay myself interest. Should I?

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Published Jun. 24

Dear Penny

Our 401(k) lets you borrow from the plan and pay yourself back at 7 percent interest.

Given today's sometimes dismal returns, it seems like a good way to pay off some debt or make a down payment. I realize you miss out on the gains, but in some situations, wouldn't you rather pay yourself that 7 percent?

-P.

Dear P.,

Mathematically, I can't tell you whether you'd come out ahead if you took out a 401(k) loan. That depends on so many factors, like the interest rate you're currently paying on the debt you'd use the loan for and how the market performs.

Generally speaking though, borrowing from your future is a bad deal — even when you're paying interest to yourself.

First, a quick 411 on 401(k) loans: Not all employers let you borrow from your 401(k), but if your plan allows loans, the IRS says you can borrow up to 50 percent of your vested balance or $50,000 — whichever is less.

The loans are tax-free and usually repaid through automatic payroll deductions. The interest you pay goes back into your retirement fund, so the appeal is obvious. Of course you'd rather pay interest to yourself instead of a bank.

But as you acknowledge, you're missing out on potential gains, which could be significant thanks to compound returns. That effect will be even greater if you reduce or eliminate your contributions while you pay back your loan, as many 401(k) borrowers do, or if your employer doesn't allow you to make contributions while you have an outstanding loan.

The real danger, though, comes if things don't go as planned.

If you leave your job for any reason, you'll have to pay back the outstanding loan balance in full when you file that year's tax return. So if you got fired or quit your job at any point in 2019, you'd need to repay your 401(k) loan balance by April 15, 2020, or Oct. 15, 2020, if you filed an extension.

But what if you can't afford to repay it? Then the IRS will treat it as an early withdrawal, which means you'll pay income tax, plus a 10 percent penalty if you're under age 59½. So suppose your outstanding loan balance was $10,000 and it's taxed in the 22 percent bracket. With taxes and the penalty, that $10,000 loan would cost you $13,200.

The risks are real. A 2015 study by the National Bureau of Economic Research found that 86 percent of 401(k) borrowers who leave their company defaulted on their loan. (Caveat: When the research was performed, 401(k) borrowers only had 60 days to repay their loans if they left their jobs. The Tax Cuts and Jobs Act of 2017 extended the time frame.)

Also, consider that a 401(k) is an asset that's protected from creditors, so you should be extra cautious about using it to pay off debt or put toward a property that could be seized if you fell on tough times.

There may be some circumstances when raiding your 401(k) is your least bad option — if you have a serious illness or are about to lose your home. If that were the case, I'd be inclined to at least consider a 401(k) loan.

But it doesn't sound like that's the case here. If you're looking to pay down debt and have decent credit, a debt consolidation loan is a better option. Sure, you'll fork over interest to a lender, but it's much less risky than a 401(k) loan. Or if you want money for a down payment, finding a down payment assistance program or good old-fashioned saving are better options for the long haul.

It's frustrating to watch your retirement balance rise and fall in a volatile market. But remember that these ebbs and flows are usually relatively minor. Saving for retirement is a long-haul game, and short-term fluctuations aren't a big deal in the larger picture.

The purpose of your 401(k) is to fund your retirement. Until then, the best advice is: Do. Not. Touch.

Robin Hartill is a senior editor at The Penny Hoarder and the voice behind Dear Penny. Have a tricky money question? Write to Dear Penny at askpenny@thepennyhoarder.com.

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