When times
are tough, that pool of dollars sitting in your 401(k) plan account may start
to look attractive. But before you decide to take a plan loan, be sure you
understand the financial impact. It's not as simple as you think.
The basics of borrowing
A 401(k)
plan will usually let you borrow as much as 50% of your vested account balance,
up to $50,000. (Plans aren't required to let you borrow, and may impose various
restrictions, so check with your plan administrator.) 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. Generally, you have up
to five years to repay your loan, longer if you use the loan to purchase your
principal residence. Many plans let you apply for a loan online, making the
process quick and easy.
You pay the interest to yourself, but…
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 latest investment direction). This means that you're not only
receiving back your loan principal, but you're also paying the loan interest to
yourself instead of to a financial institution. However, the benefits of paying
interest to yourself are somewhat illusory. Here's why.
To
pay interest on a plan loan, you first need to earn money and pay income tax on
those earnings. With what's left over 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, for example),
they're taxed again because 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"--i.e., it's been at least 5 years since you made your
first Roth contribution to the plan, and you're 59½ or disabled.)
...consider the opportunity cost
When you
take a loan from your 401(k) plan, the funds you borrow are removed 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 if they were still inside the plan, compared to the amount of interest
you're paying yourself. This is known as the opportunity cost of a plan loan,
because by borrowing you may miss out on the opportunity for additional
tax-deferred investment earnings.
Other factors
There are
other factors to think about before borrowing from your 401(k) plan. If you
take a loan, will you be able to afford to pay it back and continue to
contribute to the plan at the same time? If not, borrowing may be a very bad idea
in the long run, especially if you'll wind up losing your employer's matching
contribution.
Also,
if you leave your job, most plans provide that your loan becomes immediately
payable. If you don't have the funds to pay it off, the outstanding balance will
be taxed as if you received a distribution from the plan, and if you're not yet
55 years old, a 10% early payment penalty may also apply to the taxable portion
of that "deemed distribution."
Still,
plan loans may make sense in certain cases (for example, to pay off
high-interest credit card debt or to purchase a home). But make sure you
compare the cost of borrowing from your plan with other financing options,
including loans from banks, credit unions, friends, and family. To do an
adequate comparison, you should consider:
- Interest rates applicable to each alternative
- Whether the interest will be tax deductible (for example, interest paid on home equity loans is usually deductible, but interest on plan loans usually isn't)
- The amount of investment earnings you may miss out on by removing funds from your 401(k) plan
Broadridge Investor Communication Solutions, Inc. does not provide legal, taxation, or investment advice. All the content provided by Broadridge Investor Communication Solutions is protected by copyright. Forefield claims no liability for any modifications to its content and/or information provided by other sources.
Copyright 2011 by Broadridge Investor Communication Solutions Inc.
All Rights Reserved.
Copyright 2011 by Broadridge Investor Communication Solutions Inc.
All Rights Reserved.
