Nearly 20 percent of all tax-deferred 401(k) participants have found an easy source of credit by borrowing from their own retirement accounts. Although most plans offer loans of up to half your vested balance, this may not be a good idea. Plan loans usually charge the prime rate plus one or two percentage points. In addition, you lose all future compound interest on the lost earnings on money that was borrowed. If you quit your job or are laid off or fired, your loan may be due immediately at a time when you can least afford to pay it back.
If you have a financial emergency and your only choice is between borrowing from your 401(k) or withdrawing money from it as a hardship, then borrowing from your 401(k) may be the better choice. There is no penalty on borrowing, but a financial hardship withdrawal may result in a 10 percent penalty as well as tax on the amount withdrawn. A financial hardship withdrawal is only allowed for specific reasons (to purchase a home, pay for a college education, or pay for unreimbursed medical expenses). The withdrawal is subject to income taxes as well as a 10 percent penalty if you are younger than 59½. Other circumstances (e.g., total disability and leaving employment at age 55 or later) may result in a penalty-free withdrawal.
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