Borrowing Against Your 401(k)

by Nancy Osborne, COO of ERATE

So you've set money aside for your retirement and now you'd like to tap into it for reasons other than funding your retirement. Simply cashing out of your 401(k) plan is not a smart idea because if you are under age 59 1/2 you will be hit with an early withdrawal penalty of 10% on top of having to pay federal and state taxes on the amount withdrawn. A better option may be to borrow against your 401(k) and to follow the plan's rules of repayment so you can accomplish both your objectives of having the short term use of your money and repaying it on time so you will then have the account available for your use by the time you retire, along with the additional interest you'd be chipping in when you repay the loan. Normally you are permitted to borrow against your 401(k)in an amount equal to the lesser of $50,000 or half of the amount vested in your account. However before setting the wheels in motion to borrow against your 401(k), make sure you really need the funds for a valid purpose and that you will repay the loan on time or you could end up costing yourself both in the short and in the long run. Carefully analyze whether your intended purpose for the funds is worth the risk of jeopardizing your retirement account. There are advantages and disadvantages to borrowing against your 401(k) loan, here are some for your consideration:

Advantages:

> Low interest rate, typically only 1-2% above prime commercial lending rates.

> Good repayment terms, typically 5-10 years and possibly longer if the funds are to be used for home down payment purposes.

>Inexpensive loan fees, typically only $50-$100.

> Fast source of money, you can usually access the funds within a week's time.

> No credit check, it is your money after all, so no check is required.

> Ease of repayment, the monthly payment is deducted from your paycheck automatically.


Disadvantages:

> You are using after-tax earnings to pay for the interest on the 401(k) loan resulting in your paying taxes more than once on the money, thus increasing your over all cost of borrowing the funds.

> The opportunity cost which results from not keeping the loan funds fully invested for retirement. The interest you are paying into the account to use the funds will help to offset this, but it remains a true opportunity cost to you if your invested funds would have earned a return in excess of what you are paying back into the account in the way of interest.

> Many borrowers may find it difficult to both repay their 401(k) loan and continue making their regular 401(k) contribution simultaneously. Thus your contributions into the plan could suffer.

> Your company's plan guidelines may prevent you from making additional contributions into your account until your loan is repaid further hampering your ability to continue to save. This could hurt even more if your employer offers any type of match of your personal contributions.

> There is added risk if you should lose your job before the loan is repaid, either by choice or layoff, you will then be forced to accelerate the repayment of the loan within 60 days or be required to pay taxes and penalties at perhaps the least opportune time, when your are jobless.

> Interest paid on the loan is not tax deductible (it's similar to a consumer loan) as it would typically be if other financing options were used.


Remember to always consult with your tax or financial advisor regarding your own individual circumstances. For additional information go to: http://www.irs.gov/faqs/faq5-4.html

  Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.

"I am addicted to Bloomberg TV" says Nancy.