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Financial Focus/401(k) Loans Can Be Costly To Your Future
If you work for a company that offers a 401(k), consider yourself fortunate. A 401(k) offers tax-deferred earnings growth, the ability to make pre-tax contributions and a variety of investment choices. Your 401(k) may also offer a loan feature - but you may want to think twice before using it.
At first glance, a 401(k) loan may sound appealing. After all, youíre only borrowing from yourself, and you can make repayments gradually. Furthermore, the rate on most 401(k) loans is quite competitive. And you can usually borrow up to $50,000 or half the balance of your account, whichever is smaller. You typically have five years to repay your loan; if youíve taken the money out to purchase a home, however, you may have up to 30 years.
So, given these inducements to taking out a 401(k) loan, you might be tempted to call up your employee benefits office if youíre in need of cash. On the other hand, there are some major disadvantages to borrowing from your 401(k). Letís look at them:
* Youíll use ďafter-taxĒ dollars to repay loan - Your 401(k) contributions are typically made with pre-tax dollars, resulting in a lower taxable income for you. But when you repay a 401(k) loan, youíre using after-tax dollars, so you get no tax break. Also, those dollars will be taxed again when you eventually withdraw them for retirement. Consequently, youíll pay taxes two times on the money you use to pay back your loan - and this double taxation can greatly inflate the cost of borrowing from your 401(k).
* You must pay the loan back quickly upon leaving job - When you take out a 401(k) loan, you may plan on staying in your job for a long time. But things can change. You may find another career opportunity you want to pursue, or you may face a layoff. If you leave your job, voluntarily or involuntarily, youíll need to repay your 401(k) loan completely, usually within 60 days. If you canít, the balance will be considered a taxable distribution - and you may even have to pay a 10 percent penalty on it.
* Youíll slow progress toward your retirement goals - Possibly the most important reason to avoid taking out a 401(k) loan is that such a loan can reduce the funds youíll eventually have for retirement; the money you borrow does not have the opportunity to grow. While itís true that you will eventually pay the loan back, you will have taken some money out of the market - possibly out of a bull market. Even worse, you could find it prohibitively expensive to both pay back your loan and add new dollars to your 401(k), causing you to temporarily cut back, or eliminate, your contributions.
Clearly, youíve got some real issues to consider before borrowing from your 401(k). In fact, you may want to consider some alternatives. You can probably find a low-rate home equity loan, and your interest payments may be tax-deductible. (Keep in mind, though, that you are using your house as collateral.)
In any case, think long and hard before tapping into your 401(k). This plan was created for one reason - to help you save for retirement. Thatís a worthy goal to preserve.
This article was submitted by the financial representatives of Edward Jones in Hagerstown: Greg Garner, 301-733-9465; Dave Walker, 301-766-7300; Joan Bowers, 240-420-8514; and John R. Pullaro, 301-824-7726.
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