Dear Dagen: Consider Your 401(k) a Lender of Last Resort

The cost in taxes and lost earnings can be high.
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I'm trying to decide whether to borrow money from my 401(k) to use as a down payment for a house. What should I consider? -- Mason Adair

Mason,

You should consider asking your Uncle Louie for the money.

Borrowing from your 401(k) plan temporarily disrupts your retirement saving and subjects you to all sorts of annoying, cumbersome rules.

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Everyone seems to be house-hunting this year. Existing-home sales peaked in June, but are still on their way to a record year of more than 5 million homes, according to the

National Association of Realtors

.

So, it's not surprising that you might be in the market for a three-bedroom quasi-Colonial. However, using money from your retirement plan can be tricky.

You are allowed to borrow 50% of your vested account balance or a maximum of $50,000. Most plans will limit the number of loans you can take; you're typically allowed one to three.

Generally, you'll encounter two different loan periods. For a general purpose loan, you'll have up to five years to pay it back. For a primary residence loan, you may get, depending on the plan, up to 15 years.

Borrowing money from your plan is not a taxable event -- that is, you'll owe no taxes on the money you take out of the plan. The loan gets paid back through payroll deductions, the same way your contributions are made.

Unlike contributions, however, your loan payments are in after-tax dollars. So, in effect, you'll be taxed twice on this money. The second time will be when you eventually take a distribution from your 401(k) account in retirement.

You also should realize that your retirement account will be earning less once you take out that loan. And you'll lose the compounding on any money you take out of this account.

"You have to understand taking a loan is an investment decision," says Rich Koski, a principal at

Buck Consultants

, a benefits consulting firm in New York.

Assuming your 401(k) assets are invested in stocks or mutual funds, you could very well be losing a lot by taking that money out of the market -- particularly given what the markets have done over the past few years. Last year, the

S&P 500

rose 26.7% and is up 15.3% this year. Even better, the tech-centric

Nasdaq 100

has climbed 223% since the end of 1997.

Your account will be earning interest on this loan -- but you'll be the one who is paying it. The interest you pay may be pegged to the prime rate or may be over or under that number.

And that interest isn't tax deductible, as it would be on a home-equity loan.

All 401(k) plans have varying loan options, but many plans will allow you to continue making contributions even if you have an outstanding loan. Unfortunately, you may not be able to afford to do this. A 401(k) contribution -- on top of regular loan repayments -- could put an unbearable strain on your cash flow.

Most importantly, you shouldn't borrow from your 401(k) plan if you are planning to leave your job anytime soon.

If you quit or are fired, you'll have only a short time, usually 60 to 90 days, to repay that loan. "Relatively few plans allow you to continue repaying the loan after termination," Koski says.

If you don't pay it back immediately, the loan is considered a distribution. And that could be painful. You would then owe both federal and state income taxes on that distribution, plus a 10% penalty if you are under retirement age.

However, buying your own home could be a very important step or a big need in your life. These days, people use their 401(k) plans as their primary vehicle for saving money, says Mike McCarthy, a 401(k) consultant with

Hewitt Associates

in Lincolnshire, Ill. And sometimes, "this is the only place they can tap money."

Indeed, 23% of all plan participants borrow from their 401(k) plans, according to the most recent data available from Hewitt.

If you are taking the money out to buy a boat or some other nonessential item, the loan would be hard to justify and may not be allowed by your plan. A home is certainly a less frivolous purchase.

There is no hard and fast calculation for you to determine if you should or shouldn't borrow from your retirement plan. You can, however, look at what you would earn if you kept the money in the plan. (A site such as

Financial Engines can help you run that calculation.) Then, look at what you would make if you took the loan, assuming the same rate of return.

Also, examine what you would save in taxes if you took out a home-equity loan.

And if you are planning to leave your job, you should definitely look elsewhere for the cash.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.