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The Online Advisor - July 1999
What's wrong with borrowing from your 401(k) plan?
At first glance, 401(k) loans may seem very attractive. Rates are low compared to other forms of consumer debt. There’s not even a credit check since you’re borrowing your own money.
A closer look, however, reveals some disadvantages to 401(k) loans. When you repay your loan, you will not be getting a tax deduction for the interest you pay to your 401(k).
To improve your tax situation, consider a home equity loan. Home equity loans usually generate a current tax deduction for mortgage interest.
Home equity loans may also feature long maturities and low monthly payments. Contrast this with 401(k) loans, which generally have a five-year maximum term.
If your 401(k) investments are making a better rate of return than the rate you will be paying on borrowed funds, you will be reducing the tax-deferred accumulation of your retirement funds. It makes very little sense to cut off the high earnings of your retirement plan if you can borrow the funds elsewhere at a lower rate.
Margin borrowing may be one of many better alternatives. A margin loan is based on the current value of your brokerage account. In turn, your brokerage account serves as collateral for the loan. Your investments remain intact and continue to grow.
Changing jobs can present special problems if you have a 401(k) loan. Generally, the loan will become due when you leave your current employer. If you can’t repay the loan, any remaining balance will be treated as a taxable distribution from the 401(k) plan. In addition to current income taxes due on the distribution, tax laws provide a 10 percent penalty if you are less than 59-1/2 years old. Taxes and penalties will often equal 40 percent or more of the distribution. Other types of loans don’t represent taxable income, with or without a job change.
Alternative forms of credit often represent a better deal than borrowing from your 401(k). For assistance in evaluating the consequences of borrowing from your 401(k), give us a call.