t is tempting to borrow on your 401K to meet your obligations, pay delinquent mortgage balances, and remove some of the pressure you are facing. But is it ever a good idea?

The law says that you can borrow from your 401K and here is how that generally works. You can borrow up to 50% of the value, or $50,000, whichever is less. But if you have less than $20,000 in your account, you can borrow up to $10,000.

Your plan administrator has to allow borrowing and most do. You may pay 1 or 2 percentage points above prime rate, which isn't a bad rate for most of us. YOu have to pay the money back in five years, or if you use the money to buy a home, you have 30 years in theory. Most plan administrators limit this to ten years, though.

Let's say you don't pay the loan back on time. Then, the money you borrow becomes a withdrawal. You pay a 10% pentaly as well as income taxes on the money you have withdrawn. Ouch!

And don't forget that in general, if you pay interest on this loan, you can't deduct the interest. I do think you can deduct the interest if you use it for financing a business because interest paid for business expenses is still deductible.

I like jim's blog at www.bargaineering.com. He has a great post on borrowing on your 401K that made me think of this subject. Here's a snippet of what he writes:

 

Here are the advantages of borrowing from your 401(k):

• It’s generally really easy, no applications, no credit checks, none of the annoyances with typical loan application processes.
• Decent interest rate, generally a point or two above the Prime rate, and that interest is paid to your own account anyway.

What are the disadvantages?

• That interest rate is usually less than what the account could earn on its own with the money, plus you’re paying it anyway so it’s not coming from the market.
• The loan payment taken from your paycheck might tempt you to reduce your contribution resulting in less in savings.
• If you leave your employer, for any reason, you have to pay back the loan immediately (or within 60 days). If you can’t, it’s considered a withdrawal and you’ll owe taxes and a penalty on it.
• The terms of the loan are set in stone and there might be some fees involved. You generally pay back the loan over 5 years, it’s more if you use it to purchase a primary residence (10-15 years).

So, should you borrow from a 401k? That depends!

I think JIm's arguments are solid. But I think the trouble with borrowing from your 401K is principally that it will tempt you to be profligate. If you are in financial trouble and you see your 401K there as funds to tap, you will not work as hard finding other solutions to your financial problems.

Money in retirement accounts is privileged. It is exempt from being used to satisfy creditors in bankruptcy to a large extent. I would be very hesitant about invading my 401K for reasons of financial desperation. I might use my 401K to fund a business venture, though, although I probably would use some other type of loan, even credit card loans, instead.

The reality is that many businesses require some cash. And using your retirement money from building a business strikes me as a reasonable use of the cash. Using the retirement funds to pay back a delinquent balance on a mortgage strikes me as the wrong use of the cash. But that's just me. You have to use your own judgment here.