If you work for a company that offers a 401(k), consider
yourself fortunate. A 401(k) offers tax-deferred earnings growth,
the ability to make pre-tax contributions and a variety of
investment choices. Your 401(k) may also offer a loan feature, but
you may want to think twice before using it.
If you work for a company that offers a 401(k), consider yourself fortunate. A 401(k) offers tax-deferred earnings growth, the ability to make pre-tax contributions and a variety of investment choices. Your 401(k) may also offer a loan feature, but you may want to think twice before using it.
At first glance, a 401(k) loan may sound appealing. After all, you’re only borrowing from yourself and you can make repayments gradually. Furthermore, the rate on most 401(k) loans is quite competitive. And you can usually borrow up to $50,000 or half the balance of your account, whichever is smaller. You typically have five years to repay your loan; if you’ve taken the money out to purchase a home, however, you may have up to 30 years.
So given these inducements to taking out a 401(k) loan, you might be tempted to call up your employee benefits office if you’re in need of cash. On the other hand, there are some major disadvantages to borrowing from your 401(k). Let’s look at them:
– You’ll use “after-tax” dollars to repay loan: Your 401(k) contributions are typically made with pre-tax dollars, resulting in a lower taxable income for you. But when you repay a 401(k) loan, you’re using after-tax dollars, so you get no tax break. Also, those dollars will be taxed again when you eventually withdraw them for retirement. Consequently, you’ll pay taxes two times on the money you use to pay back your loan and this double taxation can greatly inflate the cost of borrowing from your 401(k).
– You must pay the loan back quickly upon leaving job: When you take out a 401(k) loan, you may plan on staying in your job for a long time. But things can change. You may find another career opportunity you want to pursue or you may face a layoff. If you leave your job, voluntarily or involuntarily, you’ll need to repay your 401(k) loan completely, usually within 60 days. If you can’t, the balance will be considered a taxable distribution and you may even have to pay a 10-percent penalty on it.
– You’ll slow progress toward your retirement goals: Possibly the most important reason to avoid taking out a 401(k) loan is that such a loan can reduce the funds you’ll eventually have for retirement. Any money you take out as a loan is money that does not have the opportunity to grow for you. While it’s true that you will eventually pay the loan back, you will have, in effect, taken some money out of the market – possibly out of a bull market. Even worse, you could find it prohibitively expensive to both pay back your loan and add new dollars to your 401(k), causing you to temporarily cut back, or eliminate, your contributions.
Clearly, you’ve got some real issues to consider before borrowing from your 401(k). In fact, you may want to consider some alternatives. You can probably find a low-rate home equity loan and your interest payments may be tax-deductible. Keep in mind, though, that you are using your house as collateral.
In any case, think long and hard before tapping into your 401(k). This plan was created for one reason – to help you save for retirement. That’s a worthy goal to preserve.
Financial Focus is provided by Mark Vivian, a representative of Edward Jones Financial Services. His office is at 615 San Benito St., Suite 105. Phone 634-0694.
