Tax Tips
Should You Borrow From Your 401 (k) Plan? - November 2005
Richard Scrivanich - Partner
Over 42 million Americans participate in their employers’ 401(k) plans, and over 85% of these workers are eligible to borrow from their accounts. If you are one of those eligible workers, is it a good idea to borrow from your 401(k)?
Loan basics
Some key features of 401(k) loans include:
- Typical plans enable you to borrow up to 50% of the vested balance of your account to a maximum of $50,000.
- Usually you must repay the loan over five years. A longer period may be available for a loan that is a mortgage for your primary residence.
- You can always repay your loan in full at any time with no penalties.
- Loan repayments are made by payroll deductions over the repayment period.
- If you change jobs while the loan is outstanding, most plans require you to repay the entire loan immediately.
Income tax consequences
The interest you pay on a 401(k) loan goes back into your account, and is tax deferred, just as other earnings within your account. However, you cannot deduct the interest paid.
A loan from your 401(k) plan does not trigger taxable income, provided you repay the loan over the repayment period. However, if you change jobs, you have only a short period, usually between 30 and 90 days, to repay the loan. If you do not repay the loan at that time, the IRS may consider the outstanding balance to be an early withdrawal, subjecting you to income tax on the amount of the loan, plus an additional 10% tax if you are under the age of 55 when you terminate your employment.
Pros and cons
There are both pros and cons of borrowing from your 401(k). Some advantages of 401(k) loans over other sources of credit include:
- Less paperwork and ready access.
There are no credit checks and you may be able to get your money almost immediately. Most plans let you borrow for any reason, although some restrict approval to loans for home purchase, or for education or medical expenses.
- You pay interest back to yourself.
You repay your account, both principal and interest, through after-tax payroll deductions.
- Advantageous rates:
The interest rate you pay is usually 1% to 2% above the existing prime rate.
These advantages may be compelling, but there may be significant drawbacks as well, including:
- Job change.
As indicated above, if you leave your job, you will have a very limited period in which to repay your loan in full in order to avoid income taxes and penalties.
- Fees.
Most plans charge a one-time loan fee. Many plans also charge a yearly or quarterly service fee.
- Market cost.
To the extent your 401(k) nest egg is invested in market-priced investments, the loan proceeds will come from selling shares in those investments. If the market is down when you take a loan, you may be selling your investments at a loss, reducing your long-term investment return.
- Probability of slower investment growth.
Although interest on a loan is paid directly back into your account, chances are you could earn a better return if borrowed money remains invested instead. Additionally, while the loan money is out of the 401(k) account, it loses the tax-deferred compounding of returns it would have earned had those funds not been removed.
- Tax disadvantage.
Interest you pay on the loan is not tax-deductible, unlike the interest on a home equity loan or home mortgage.
- Carefully consider the details.
If you are thinking about a 401(k) loan, you should consider all alternative borrowing sources. For example, a home equity loan may be a better choice, since the interest paid on a home equity loan may be tax deductible if you itemize your deductions on your individual return.
Your 401(k) plan may be one of the most important sources of income when you retire. You want your plan balances to grow as quickly as possible, and taking a loan will probably slow down that growth. Think twice before borrowing from your 401(k) plan. If you are considering a 401(k) loan, call us to discuss how a loan may best fit into your financial plan.
If you have any questions regarding whether or not you should borrow from your 401(k) plan or any other tax matter, please feel free to give me a call at (562) 698-9891.
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