401k Layoff Trap
Using Your 401k to Pay Off Debts
401k Loans: Borrowing Your Own Money
Dear Dollar Stretcher,
We "borrowed" money from our 401K a few years ago and again just last year. Don't know if other 401K plans do this - but we are allowed to borrow up to half of the amount in our account with no collateral and make monthly payments at about 8 or 9 percent interest. This means we are actually paying ourselves interest on our own money. In our experience, we've still been earning great dividends in our account while paying on the loans.
Lorrie's right. About 75 percent of all 401k plans will let you borrow against your account. And about one-third of people who participate in plans borrow from them. But is it a good idea? If you ask your co-workers, you'll find that many of them think so but aren't that sure how the whole thing works. Let's try to clear some of the fog.
Start with some facts. The law limits you to borrowing 50 percent of the account's value or $50,000, whichever is less. Unlike just about any other loan, there's no credit check. Borrowers have five years to pay the money back. If the loan has been used to purchase a home, the law allows up to 30 years for repayment, but many plans limit the time to 10 years.
You'll be charged an interest rate that's considered competitive with other lenders. That's an IRS requirement. Often plan administrators set the rate at prime plus 1 percent.
You won't pay taxes on the amount that you borrow. Taxes come into the picture if you don't repay your loan on time. Then you would pay a 10 percent penalty as well as ordinary income taxes on the withdrawn money.
Usually a payroll deduction is used for repayment. Obviously this makes it less likely that you'll miss a payment. But it also means that you won't be seeing the money in your paycheck. If you need it for groceries, well, that's just too bad.
You'll also need to remember that you can't deduct your interest expense on 401k loans. That might make a home equity loan look more attractive.
A caution: some plans will allow or even require that you reduce or eliminate new contributions to the 401k plan while you have a loan outstanding. You might think that it's handy to use that "extra money'" to help repay the loan. But that's something that you need to consider carefully. For instance, if you're 30 years old now, every dollar that you don't put in the plan today could cost you $30 when you're 65.
So how can you tell if it's a good deal financially? Most people compare the interest rate that they'd get elsewhere to the rate offered on a 401k loan. That's a good place to start. If the rate on the 401k loan is higher, you probably don't need to go any further.
But, even if you could save by borrowing from your 401k plan, that's only half of the equation. The other half is to compare whether your plan will be earning less by loaning you money. Remember, this time you're not only the borrower, but also the lender. A low rate could affect the growth in your 401k.
To check, compare the interest rate you'd be paying on the loan to other investment options in the 401k. For instance if you've been earning 11 percent within your 401k and your loan would cost 9 percent, you'd be losing 2 percent per year within your account.
That might not seem important now. But take our 30-year-old as an example. Let's suppose that he's borrowing $10,000 and will be paying 9 percent interest, but could have earned 11 percent in another 401k investment option. His 401k balance in five years will be about $1,000 less if he takes the loan. And that amount will be worth about $15,000 when he retires and wants to begin taking withdrawals.
There are other concerns that you need to consider before making a loan. Are you a good credit risk? Iif you fail to repay you face three consequences. First, if you're younger than 59 ½, you'll pay a 10 percent penalty for an early withdrawal from your 401k. You'll also owe income taxes on money that you don't have. And, you'll have less money in the plan when you retire.
Another thing to consider is what will happen if you leave your employer before the loan is repaid. Many plans give you just 30 or 60 days to pay back the entire loan if you leave your job. If you don't, it's considered a withdrawal and the taxes and penalties kick in.
Finally there are some tax issues that aren't obvious unless you think about what's happening. One of the advantages of a 401k plan is that the money you contribute isn't included in your income for taxes each year. So it enters the plan "pre-tax." All the time it's in the plan there are no taxes paid on the earnings. Only when you retire and begin to take withdrawals are you taxed at your regular rate.
If you take a 401k loan you'll have money deducted from your paycheck. That money will have income taxes deducted before it's applied to your loan. And then when you finally retire and take the money out of the plan you'll have to pay taxes on that money a second time. Of course, in fairness, if you had taken a regular car loan from your Ford dealer you would make payments and never see the money again.
A 401k loan can work out well if you need money for a one-time, planned purchase. But, if you already have a mortgage, car loans and maxed-out credit cards, it's probably a very bad idea to borrow from your 401k. The debts that you already have will make it hard to save for retirement. If you empty your retirement accounts, too, your senior years could be anything but golden.
Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report and he's a regular contributor to US News Money and CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+.
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