According to a recent study by AARP, many Americans are risking their financial futures in order to fulfill with an immediate need. In fact, 23% of consumers surveyed by AARP said that they have prematurely tapped their retirement funds. A survey by Transamerica Center for Retirement Studies found that 18% percent of workers had a loan outstanding from their retirement plan in 2007, up from 11% in 2006.
If you plan to borrow from your 401(k) retirement plan, be careful. Plan loans usually charge the prime interest rate plus one or two percentage points. Because the interest you pay goes right back into your 401(k) account, you might think of this as a "free" loan. Not so. In fact, it could cost you more than the stated rate. Say you borrow from your plan at 10% but the cash you pull out has been earning 12% in the stock market. You are losing out on the additional earnings. And you lose future compounding on these lost earnings. In time, that could amount to quite a nest egg.
Another potential problem is that if you quit or lose your job, your loan may be due immediately. This could be at a time you may least be able to afford to pay back the loan. If you can't pay back the loan, the loan is considered a distribution. That means you will owe taxes on this distribution and, if you are under age 55, you will get hit with a 10% early withdrawal penalty too.
For more about the cons of borrowing from your retirement, read this post by Linda Rowley.