I'm short of cash and thinking of raiding my 401(k). What are the pros and cons?
I'll give you the good, the bad, and the ugly on borrowing from your account. Sort it out, and I think you'll agree with my view that you should consider borrowing only if you have an emergency on your hands. Even then, I'd frist explore other options, such as a home equity loan.
The good
The biggest plus is convenience. No credit checks, no hassles with loan officers and bank paperwork. Although loan eligibility rules can vary from plan to plan, more than 90 percent of 401(k)s allow participants to borrow as much as half the money in their accounts to a maximum of $50,000. The terms aren't half bad either. Most plans give you five years to replay the loan, unless you're borrowing to buy a house, in which case you may get as long as 10 to 30 years. The rate is usually one to two percentage points above the prime borrowing rate, which would make the going rate on 401(k) loans a reasonable 8 percent to 9 percent these days. Perhaps best of all, you're paying interest to yourself, since all your payments go right back into your 401(k) account.
The bad
Borrowing can reduce the amount of wealth you build long-term. Most obviously because the amount you borrow earns only the interest rate you pay yourself, not the higher returns that stocks generally provide long-term. But there's another reason: the financial strain of repaying the loan could lead you to contribute less or even stop contributing to your plan .If you use the loan to finance the purchase of a house, you can't deduct the interest from your taxes, as you can with a home mortgage. And remember that you use after-tax dollars to repay the interest on your 401(k) loan, which means that money is taxed once. When you eventually pull those dollars out of your 401(k), they're taxed again. That double taxation effectively raises the rate on your 401(k) loan.
The ugly
If you leave your job -- voluntarily or not -- with the loan outstanding, your (former) employer may require you to repay the balance in full, usually within 60 days. Fail to do that, and the IRS will consider any remaining balance as a withdrawal, which means you'll owe income taxes on the balance, plus a 10 percent penalty if you are under 55.
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