Action Line: Consider options before borrowing from your 401(k)
BY PHIL MULKINS World Action Line Editor
Friday, January 11, 2013
1/11/13 at 4:45 AM
Dear Action Line: My sister lost her job four years ago and is about to borrow from her 401(k). I tell her not to but she's desperate. What can YOU tell her? - C.M., Tulsa.
The tax law surrounding 401(k) plans lets you borrow up to 50 percent of your vested account balance, up to $50,000, said Sylvia Karimian, certified financial planner and co-owner of Karimian & Accociates in Tulsa, an Ameriprise Financial Services practice.
Interest paid: Plans aren't required to let you borrow and some impose restrictions. You pay the loan back, with interest, from your paycheck. Most plan loans carry a "favorable interest rate, usually prime plus one or two percentage points. Borrowers usually have up to five years to repay 401(k) loans, longer if they use the loans to buy a principal residence. Many plans let you apply online, making the process quick and easy.
Pay interest to yourself: When you make payments of principal and interest on the loan, the plan generally deposits those payments back into your individual plan account (in accordance with your investment direction). This means you're not only receiving your loan principal back, but also you're paying the loan interest to yourself instead of to a bank. However, the benefits of paying interest to yourself are deceiving.
The math: To pay interest on a plan loan, you first need to earn money and pay income tax on those earnings. With what's left after taxes, you pay the interest on your loan. That interest is treated as taxable earnings in your 401(k) plan account. When you later withdraw those dollars from the plan at retirement they're taxed again as plan distributions are treated as "taxable income." In effect, you're paying income tax twice on the funds you use to pay interest on the loan. If you're borrowing from a Roth 401(k) account, the interest won't be taxed when paid out if your distribution is "qualified" (if it's been 5 years since your first Roth contribution and you're 59 1/2 or disabled).
Opportunity cost: A 401(k) loan takes the funds from your plan account until you repay the loan. While removed from your account, the funds aren't continuing to grow tax deferred within the plan. So the economics of a plan loan depend in part on how much those borrowed funds would have earned had they remained in the plan, compared to the amount of interest you're paying yourself. This is the "opportunity cost" of 401(k) loans as you miss the opportunity for additional tax-deferred investment earnings.
Another wound: Can you afford to pay it back and continue contributing to the plan at the same time? If not you wind up losing your employer's matching contribution. When you leave your job, your loan comes due. If you don't have the funds to pay it off, the outstanding balance is taxed as a plan distribution, and if you're not 55, a 10 percent early payment penalty applies to the taxable distribution.
Alternatives: Compare the cost of borrowing from your plan with other financing options: loans from banks, credit unions, friends and family. Consider interest rates applicable to each alternative, whether the interest is tax deductible (interest paid on home equity loans is but interest you pay on plan loans isn't) and the amount of investment earnings you missed by removing funds from the 401(k).
Original Print Headline: Consider options before borrowing from your 401(k)
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