Tax Tips
Taking a 401(k) Loan May Be Borrowing Trouble - August 2009
Richard Scrivanich - Partner
You may find it difficult to get a loan in today's credit crunch. If you need money, one option is to borrow against your 401 (k) account. Before you take that step, however, consider the downsides as well as the advantages.
Pros
Many employers allow 401 (k) participants to borrow against their account. Federal law limits these loans to 50% of the vested 401 (k) account balance or $50,000, which is less. These loans are easy to get: You won't be rejected because your credit score or income is too low. And they're easily processed, with little or no paperwork.
Once you borrow from your 401 (k), you'll repay the debt from paycheck deductions. Therefore, you'll be paying interest to yourself rather than a bank. In effect, the terms of the loan assure that you put money back into your retirement account, with interest.
Cons
If 401 (k) loans are simple and straightforward, what are the negatives? One is the risk that the consequent paycheck reduction will be daunting. You might cut back on your regular 401 (k) contributions in order to repay the debt and ultimately save less for your retirement.
These arrangements present a tax trap as well. The money used to repay the debt will come out of your paycheck, not from a salary deferral, so you'll be using after-tax dollars. Because you'll pay tax on eventual 401 (k) withdrawals, you'll actually pay tax twice on those amounts.
Moreover, the current economic climate poses extra risks for 401 (k) borrowers. If you are laid off, you'll have to repay the outstanding loan balance, perhaps within 60 days of leaving the company. If you fail to comply, you might owe income tax on any unpaid amounts and a 10% early withdrawal penalty if you're younger than 59½.
Therefore, you should consider borrowing from your 401 (k) only if you truly need the money, you have no other practical source of funds, and you're reasonably confident of your job security.
If you have any questions regarding the above discussed topic or any other tax matter, please feel free to give me a call at (562) 698-9891.
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