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Eight tips to get the most from your 401(k) plan
In 1998, 9% of the nation's 401(k) participants took loans against their 401(k) plans.
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The Basics
Warning: 401(k) loans are hazardous to your wealth
Borrowing from your 401(k) plan should be your last solution, not your first, when you need a loan fast. Here's a look at the pros and cons.
By Ginger Applegarth
It sounds so simple. You need some quick cash because of a financial emergency and you decide to borrow from your 401(k) retirement plan. After all, it's your money and the interest and principal you pay goes back into your account. But as with most financial issues, it's not as simple as it sounds.
In fact, for most people, borrowing from a 401(k) is not the best solution.
The rules:
If your 401(k) plan allows loans (most do), you can borrow up to 50% of your vested account balance or $50,000, whichever is less. You usually have a maximum of five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback.
Before we get into the pros and cons, one caveat up front: If you've got a financial emergency, and your only choice is between borrowing from your 401(k) plan or pulling the money out in a hardship withdrawal before you're age 59 1/2, it's a no-brainer. By all means, borrow the money. That's because there is no penalty on borrowing, but there is a 10% penalty on early distributions.
Now, let's go through the pros and cons of borrowing from your 401(k).
The pros:
- 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.
There is a low interest rate. You pay the rate set by the plan, usually a couple of percentage points above the prime rate.
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.
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.
It's convenient. Some plans only require you to make a phone call, while others require a short loan form.
The cons:
- About that credit check: Of course there isn't one. You're not borrowing anything. You're spending your own money.
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.
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.
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.
The loan isn't tax deductible. It's considered a consumer loan, so there is no tax advantage.
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.
The bottom line:
It's better for most people to take out a home-equity loan if they're homeowners. In most cases (unless you're borrowing more than the value of the home), you can deduct the interest on your taxes.
Another option is to use money currently sitting in a low-interest rate savings account or money market fund.
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