401k Planning

Bits of Advice About 401k Loans

The financial crisis has more people than ever looking for ways to get access to their 401k nest eggs. Most employees can access their 401(k)’s by taking a loan or a more difficult to get “hardship withdrawal“. Almost 90% of 401(k) plans allow participants to take loans, and many do. But before turning your nest egg into scrambled eggs, you should consider the following bits of financial advice on 401k loans culled from some widely respected sources:

charles SCHWAB oninvesting (Fall 2009)

Q Should I Borrow From My 401(k) Plan?

A In a word, no. Borrowing from your 401(k) plan isn’t a good idea unless you have no other options. Here’s why:

  • Until you repay the loan, you’ll have a smaller portfolio to take advantage of your 401(k)’s potential tax-protected growth, likely reducing its size at retirement.
  • You must repay the loan in full, with interest, within five years. If you don’t repay in that time, the loan is considered a distribution and you’ll have to pay income tax on the outstanding balance – plus an early withdrawal penalty if you’re under age 59-1/2.
  • Similarly, the loan is considered a distribution if you leave your job for any reason and don’t repay it in full within a set time-frame – typically 90 days.
  • There isn’t a fee for borrowing from a 401(k) plan, but it’ll cost you more to repay the loan than it costs to contribute the money in the firsrt place: Loan repayments, unlike contributions, must be made with after-tax dollars.

msn money

(L)et’s go through the pros and cons of borrowing from your 401(k).

The pros:

  1. There is no credit check. You don’t have to apply for the loan, and you can make plans knowing that you will get the loan.
  2. There is a low interest rate. You pay the rate set by the plan, usually a couple of percentage points above the prime rate.
  3. It provides a great return. If your money market account is earning 3% and you pay yourself back at 6% or 7%, it looks like a good deal.
  4. The interest is tax-sheltered. You don’t have to pay taxes on the interest until retirement, when you take money out of the plan.
  5. It’s convenient. Some plans only require you to make a phone call, while others require a short loan form.

The cons:

  1. About that credit check: Of course there isn’t one. You’re not borrowing anything. You’re spending your own money.
  2. You’re losing interest. The net effect is that you have less money to invest and to earn interest. The money you borrow — or take out — of your retirement plan no longer appreciates in value from interest, dividends and/or capital gains in conjunction with the rest of your investment portfolio. Remember that you aren’t really borrowing. All you are doing is using money from one account, such as your checking or savings account, to repay the money you borrowed from your 401(k). And when you take money out of that checking or savings account, that money loses interest, too.
  3. It’s not tax-sheltered money anymore. Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars. So, let’s say your monthly interest payment is $300 and you’re in the 28% tax bracket. You’ll have to make $416 in gross earnings to make the $300 payment. Then, when you retire and take withdrawals, you pay taxes yet again.
  4. Unless you repay the loan, it is considered a premature distribution. You would owe federal and state income taxes as well as that 10% penalty if you are under age 59 1/2.
  5. The loan isn’t tax deductible. It’s considered a consumer loan, so there is no tax advantage.
  6. It affects your psychology toward retirement saving. If possible, your retirement money should sit untouched until you retire. It’s too easy to get in the habit of dipping into your 401(k) instead of saving for things you need along the way. Keep your 401(k) in a loan free zone.

Kiplinger.com

(W)orkers who are considering taking a 401(k) loan to be aware that should they default, 40% or more of the money could go to the government, assuming 25% in federal taxes and 5% in state taxes, plus the 10% early-withdrawal penalty. So you might net only $4,500 from a typical $7,500 loan.

ABC News

(Here’s) a list of four questions potential 401(k) borrowers might ask themselves before taking out a 401(k) loan through an employer:

  1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home equity, etc.)?
  2. Would the after-tax interest rate on the alternative (non-401(k)) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?
  3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?
  4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?

A “yes” answer to each of the four questions could mean a 401(k) loan is a better option. A single “no” suggests other options should be considered.

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