Money Watch: Pros and cons of a 401(k) loan
- You pay yourself back for a 401(k) loan rather than the bank
- If you leave your job, you'll have to immediately pay off the loan in full
- You are putting your retirement savings at risk
Money Watch, a personal finance column that runs every Saturday, features a financial planner from the National Association of Personal Financial Advisors answering reader questions about saving, protecting and growing your money. To submit a question, e-mail USA TODAY personal finance reporter Christine Dugas at: cdugas@usatoday.com.
Q: My 401(k) plan through my employer allows me to borrow against the balance. The interest rate on the loan is 9%, which I would pay to the fund (myself). I have college loans for my children that I will begin paying in four years. Is it a good idea for me to borrow $50,000 from my 401(k)? I cannot currently earn 9% on my 401(k) investments.
A: 401(k) loans are helpful in some limited circumstances.
You don't need to qualify through a credit check, and you don't have to tell anybody why you are borrowing the money. It's true that you pay interest to yourself and that 9% rate sure looks attractive to receive the interest in your 401(k) account.
Advantages aside, borrowing from your 401(k) plan usually is not a good idea for a couple of reasons.
For one, your loan repayments are being made with after-tax dollars. In other words, you will be paying off your loan from your income, which has already been taxed. Except mortgages, that's true of most loans.
The problem with a 401(k) loan is that, when you withdraw your account balance at retirement, your withdrawals will be taxed. That means you will pay income taxes on the same money twice.
Another serious problem with 401(k) loans can arise if you leave your current employer before the loan is paid. When this happens, your loan is immediately due in full and if you don't pay it, the balance that you owe will be considered a distribution and you will owe income taxes on the full amount.
Even worse, if you are younger than 59½, you will owe an additional 10% tax penalty on the amount distributed.
And 401(k) loans, unless secured by a mortgage, must be paid back over a period not to exceed 60 months. In your case a $50,000 loan would cost you about $1,030 a month. You need to ask yourself if you can make those payments and still make contributions to your plan and meet your other obligations and goals.
A better alternative, if you can do it, may be to refinance your home or, if you really can afford the payments, put aside $1,030 in an investment account to help meet your college loan obligations when they start to come due in four years.
Frank Boucher, NAPFA-Registered Financial Advisor
Boucher Financial Planning Services, Reston, Va.
Previous Money Watch columns:
Tips on tackling credit card debt
Making life insurance benefits last
Maximizing your Social Security