Thursday, June 9, 2011

Use Caution When Borrowing from Your 401(k)

Many people who need a loan, turn to their 401(k). Although this is tempting, there are potential pitfalls that can really mess things up for you.  Here is a short discussion of the loan characteristics.

Loan Generalities:
Specifics of the loan are determined by your plan administrator. However, here are some general loan characteristics. Usually, there is a loan initiation fee, less than $100. For most loans, the term is 5 years. But, there is an exception if you are purchasing a house as your main residence, the term is longer.

You can borrow up to $50,000 or 50% of your vested balance, whichever is less. However, there is a 12 month look back period that can reduce the new loan amount by the highest balance of the previous loan.  There may be a minimum loan amount; the plan administrator does not want to be processing $100 loans.

What’s Good About It?           
In essence, you are borrowing from yourself. The interest that you are paying is going into your account. Also, the loan does not show up on your credit report (maybe good or bad).  If you meet the loan requirements, it’s pretty much a guarantee that you will get the loan.  Usually, there is no talking to a loan officer to qualify. In many cases, everything is handled online.

What’s Bad About It?
Like most loans, problems arise when you can’t pay off the loan. However, a 401(k) loan has some additional “thorns”.

If you leave your job, for any reason, you have 60 days to repay the loan in full. If you don’t, the loan becomes a distribution. This means that you are going to owe income tax on the loan balance. And, if you are under 59 ½, you will probably be assessed a 10% penalty on the balance. In a worst case scenario, you lose your job, you can’t pay back the loan, and you owe taxes and penalties on the loan. These are extra bills at a really bad time.

Remember, you are removing money from your investments. So you are losing a potential capital appreciation.

From an income tax standpoint, there are some subtle negatives. When you pay back the loan you have to do it with post-tax funds. So that post-tax money gets into you pre-tax 401(k). And, when you finally start taking distributions during your retirement you will be taxed again on that post-tax money that you paid back the loan with. So, you've kind of paid tax twice on the loan.

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