Why Taking a 401(k) Loan Is Risky

If you're in a short-term cash crunch, should you raid your 401(k) plan and take out a loan?

Many Americans do, according to a study from the Pension Research Council at the Wharton School at the University of Pennsylvania. That study showed 20 percent of 401(k) plan participants had loans outstanding from their plans, while 40 percent have borrowed at some time or other in a five-year period between 2009 and 2014.

Some of the most common reasons cited for 401(k) loans are paying for college education, medical expenses and the down payment on a home, says Craig G. Bolanos Jr., chief executive officer at Wealth Management Group outside of Chicago.

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"Typically a 401(k) loan is limited to the greater of 50 percent of your vested account balance up to a maximum of $50,000," he says. "And know that 401(k) loans typically need to be repaid over the course of five years."

A sound decision? But is borrowing from your retirement fund a good idea? All things being equal, not really.

"Most 401(k) plans have a loan provision, but borrowing from the plan is generally not advisable," says Kevin Driscoll, vice president of advisory services with Navy Federal Financial Group.

Driscoll says the moment your money leaves the account, it's no longer tax-deferred, and you'll have to repay that money with after-tax dollars.

"In addition, you'll face a penalty for withdrawing funds early and stunt the growth of your investments," he says.

Ponder the future. An additional risk to consider when contemplating a 401(k) loan is your future with your employer, Driscoll says.

"Changing jobs without fully paying off a loan will result in the balance being paid off by funds in the 401(k)," he adds. "The payoff will be considered a distribution by the IRS and may result in additional income tax and/or penalties."

Driscoll says borrowers should look to other options such as home equity and credit cards to avoid tapping their 401(k) plans.

"However, you may borrow from your 401(k) as a last resort in certain scenarios," he says. "For instance, if the loan is used to further your career or business, strive for an uptick in salary or revenue so you can put more money back into your account, then it could be viable. Seeking counsel from a financial advisor is a great course of action to ensure you avoid fees and utilize tax advantages."

Repay promptly. There are a few advantages to borrowing from a 401(k), as long as you pay back the loan promptly.

"One of the pros of a 401(k) loan is that the interest rate is usually reasonable compared to other options like a cash advance on a credit card or a payday loan," says Ryan Kay, a financial advisor at AMI Investment Management in Kendallville, Indiana. "You also pay yourself that interest rate."

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But Kay sees plenty of downsides, too.

"One con of a 401(k) loan is if you were to ever leave the company, the outstanding balance on the loan is defaulted and becomes taxable income for that year," Kay says.

"If you terminate employment, your loan generally becomes due and payable in full immediately. Sometimes a company will allow you to pay back the balance in 30 days, but this isn't a feasible option for most people who take 401(k) loans," he adds. "Plus, the money you took out for the loan is no longer invested in the investment portfolio and instead grows at that fixed interest rate you are paying yourself."

The takeaway. In general, taking a loan from your 401(k) plan is bad business.

"We actively discourage retirement investors from cashing out retirement accounts prematurely," says Neal Ringquist, executive vice president of sales and marketing, at Charlotte, North Carolina-based Retirement Clearinghouse.

"As taking out a loan from a plan is the first step to possible retirement plan leakage, we would encourage participants to look elsewhere for a loan first," he says. "If they have no other choice but to tap into retirement savings for a loan, they should make every effort to pay back the loan and avoid default."

[Read: 5 Ways to Turbocharge Your 401(k).]

There is substantial downside risk linked to 401(k) loans. Raiding your retirement fund really is more trouble than it's worth.

Brian O'Connell is a Bucks County, Pennsylvania, business writer and author. A former Wall Street bond trader, O'Connell is the author of two best-selling books, and is a frequent contributor to TheStreet.com, CBS News, Bloomberg and other major media business platforms.