The Enron story has made people aware of the importance of protecting their 401(k) plans. And yet, not all hazards to your 401(k) come from irresponsible management – you can endanger your plan’s well-being all on your own. How? By borrowing from it.
At first glance, you might think that a 401(k) loan seems like a pretty good deal. After all, some plans may allow you to borrow up to 50% of your account balance for any purpose, provided you pay it back within five years. In fact, you could have up to 30 years to repay the loan if you use it to purchase a home. Plus, your loan’s interest rate will likely be competitive. And, because you’ll be paying yourself back through automatic payroll deductions, you won’t have to worry about missing a payment, as long as your employment situation doesn’t change.
Despite these apparent benefits, however, you won’t want to rush into taking out a 401(k) loan, because you have some substantial drawbacks to consider. First of all, if you leave your job – voluntarily or involuntarily – you no longer have five years in which to repay your loan. Instead, you’ll have to pay it back right away, typically within 90 days. If you’ve just been laid off, that repayment will represent yet another financial burden for you.
And that’s not the worst of it. If you don’t repay the loan right away, it is considered a withdrawal – which means it is taxable income. Not only will you have to pay taxes on the loan balance, but you’ll also owe a 10 percent early withdrawal penalty if you’re under 59-1/2.
Even if you stay at your job and make regular repayments on your loan, you may not be making the wisest use of your money. Your 401(k) contributions were made with pre-tax dollars, which lowered your annual taxable income, but your loan payments are made with after-tax dollars, so you don’t get any tax advantages. Plus, your 401(k) loan carries significant opportunity costs. Although you’re repaying the loan at a reasonable interest rate, your money could possibly be earning a higher rate if invested elsewhere. Many loan programs also carry additional costs, such as annual fees or disbursement fees. You’ll need to evaluate these expenses when you’re considering the loan’s real cost.
Finally, the more money you borrow from your 401(k), the less your total amount will grow, because you’ll lose some of the value of compounding. So, after you retire and start making withdrawals from your 401(k), you’ll have less money to draw from.
You may find it frustrating that a 401(k) loan carries so many problems. Yet, there is one overriding reason for all these obstacles: Your 401(k) is designed to help you build resources for retirement. That’s why this type of plan was created, and that’s why it’s so popular today. So, use your 401(k) wisely. And, if you do feel compelled to take a loan from your plan, at least be aware of the true costs involved.
-This article is provided by Jeff Foster, the Edward Jones Investment Representative for Seymour, TN.

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