What You Need to Know About 401(k) Loans

More people are taking loans from their 401(k)s to get them through tough times, according to a report released August 20 by Fidelity, a top provider of workplace retirement plans. Eleven percent of 401(k) participants took loans from their accounts over the past year, up from 9% the previous year. A total of 22% of 401(k) participants have loans outstanding, and the average amount is $8,650.

Borrowing from yourself (your savings, that is) might seem like a good idea. Most workplace-based retirement plans allow you to borrow up to half of your balance, up to $50,000. But these deals might not be as good as they seem. Here's what you need to consider before you tap your 401(k) for cash.

-- You have to pay the loan back in five years (except for home purchases, which are eligible for a longer loan period). Most employers deduct monthly loan payments from your paycheck.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

-- You'll have to pay interest on the loan (usually the prime rate plus one or two percentage points). But the interest you pay goes back into your account. That doesn't mean the money is free, though.If borrow from your 401(k) at a 6% rate but your account had been earning 8% in a stock fund, you're falling two percentage points behind. Plus, you lose future compounding interest on those lost earnings.

-- If you default on your loan, it will not hurt your credit score. However, you will owe income taxes -- plus a 10% early-withdrawal penalty if you're younger than 59½ and still working -- on the unpaid balance. You will receive a Form 1099 (and the IRS will receive a copy) that shows the amount on which you owe taxes. You have until April 15 of the following year to pay the tax.

-- If you quit or lose your job, you'll have to pay the loan back (usually within 60 days). If you don't, the money will be treated as a distribution, making it subject to federal and state taxes plus a 10% early-withdrawal penalty if you are younger than 55.

Before borrowing from your 401(k), consider other sources of cash or ways to cut expenses first. See 11 Ways to Get Extra Cash and 107 Ways to Save. Also, you can withdraw contributions from a Roth IRA tax-free and penalty-free. If you have whole life insurance, you can borrow up to the full cash value -- and you won't have to repay the loan.

Follow me on Twitter