Should you take out
loans on your 401(k)?

January 17, 2000
By Mike Kelley Financial FocusYou may not like the company cafeteria, and you may not have the best parking space, but if your employer offers a 401(k) plan, then you’ve got at least one pretty good “perk” at work.In fact, a 401(k) is one of the best retirement-savings vehicles available. Your contributions are made with pre-tax dollars, which means you can lower your taxable income. And your 401(k) earnings grow tax-deferred, so you pay no taxes until withdrawal, usually at retirement. Consequently, your money has the potential to accumulate much faster than if it were placed in an investment on which you paid taxes every year.Many people take advantage of another feature offered by a 401(k): loans. Your 401(k) plan may allow you to borrow money from your account. Typically, you can borrow up to half of your vested account balance, or up to a maximum of $50,000.The question really isn’t whether you can borrow money from your 401(k) - it’s whether you should. As with most financial decisions, there are “pros” and “cons” to consider.On the “pro” side:• You’ll have ready access to needed cash. Most 401(k) plans permit you to borrow money for any reason - and you may be able to get your money within a week.
• You pay interest back to yourself. You’ll have to pay your account back through after-tax payroll deductions. The interest rate charged on your 401(k) loan may be slightly lower than that of a bank loan, but the 401(k) loan rate would still have to be competitive. However, the exact rate depends on your individual plan.On the “con” side:• You may be missing out on investment growth. Your account might be able to earn more if you left the money invested, despite the fact that you’re paying interest to yourself on loans. Over the past several years, for example, the Standard & Poor’s 500 has averaged more than a 15 percent annual return. But if you had borrowed from your 401(k), and you were repaying yourself, you may have earned interest of only 8 percent or 9 percent.• You may have to pay off a lump sum if you leave your job. Most plans require you to repay your loan within five years. If you leave your job, you will probably have to repay the outstanding balance within 30 to 90 days. If you can’t make the payment, your loan will be considered in default, and the balance will be considered as a taxable withdrawal. If you are under age 59 1/2, you also may have to pay a penalty for early withdrawal. (However, if you are 55 or older when you leave your job, you may be able to avoid this penalty.)You’ll have to weigh these and other issues before you decide whether to take out a 401(k) loan. Keep in mind, however, that your 401(k) is a retirement plan. The government provides 401(k)s with special tax advantages, with the specific purpose of helping people save for retirement - a huge need for most people. So, think long and hard before using your 401(k) for some other purpose, no matter how tempting.

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