By Milton Zall
November 2000 - About 90 percent of employers now let employees borrow from their 401(k) plans, according to Hewitt Associates, an employee benefits consulting firm in Lincolnshire, Illinois. That figure has risen from 67 percent in 1991. David Wray, president of the Profit Sharing/401(k) Council of America, says that about one-third of all 401(k) plan participants borrow from their plans, with loans averaginge nearly $6,000.
At first glance, a 401(k) loan looks great. After all, it's your money, and when you pay yourself back, the interest and principal go back into your retirement plan. There are no credit checks and few hassles. Most plans allow for flexible arrangements and allow you to borrow for any reason. Depending on the requirements of your plan, you could have a check in about a week. Often, a call to an 800 number gets you the money. Some employers have restrictions and require a bit of paperwork, however, so ask for a list of your plan's rules.
Despite the convenience, borrowing from your 401(k) should be a last resort, not the first. Where's the rub? Here are the cons of borrowing from your 401(k).
-- You're losing interest income. The net effect of borrowing from your plan is that you're left with less money to invest. The borrowed money no longer appreciates from interest, dividends, or capital gains in conjunction with the rest of your investment portfolio. Suppose you borrow the money at an interest rate of 9.75 percent, and the money had been earning a 15 percent return in a stock fund. That 15 percent represents the real cost of your loan. But you also lose all future compounding on the lost earnings, so depending on interest rates, you could lose a lot more.
-- Your repayments aren't tax-sheltered. Whether you repay the 401(k) loan out of your salary or from a bank account, those payments constitute after-tax dollars. If your monthly interest payment is $600 and you're in the 28 percent tax bracket, you'll have to make $832 in gross earnings to make the $600 payment.
-- Most plans have a five-year window for repaying loans. If you leave your company (even if it's the employer's decision, not yours), most plans require you to repay the outstanding balance within 30 to 90 days. If you can't repay the money, your loan is considered in default and the outstanding balance is treated as a taxable withdrawal. You then owe income taxes on the outstanding balance, and if you are under age 59½, you also owe an early withdrawal penalty of 10 percent. This type of development – which happens frequently – often forces individuals to cash in more of their plan assets to make the payments, and that makes more money subject to taxes and possible penalty.
-- Borrowing from your nest egg alters your perspective toward retirement saving. 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 along the way.
-- Some plans may charge fees when you borrow from your account.
-- What if things get tight, and you are able to make only the mandatory loan payments and have to forgo any new contributions until you pay off the loan? In that event, borrowing from your 401(k) plan could leave you with less in your account at retirement than anticipated, and it could shrink your account considerably if you lose your job.
So if you need money, it's better to take out a home equity loan if you're a homeowner. In most cases you can deduct the interest on your taxes. Another option is to use money that is currently sitting in a low-interest savings account or money market fund. Wise investors consider borrowing from their 401(k) plan only when they're left without any other choice.
Milton Zall is a free-lance writer based in Silver Spring, Maryland, who specializes in tax, investment, and human-resources issues.
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