Is it ever okay to take out a 401(k) loan?
The numbers aren't always bad, but the risk is still high.
(Money Magazine) -- With the credit crunch making loans harder to come by, you might be tempted to borrow against your 401(k). The terms are attractive, after all. The rate is low - generally a percentage point above prime, which came to 6% in August - and the interest and principal go back into your account.
No wonder nearly one out of five 401(k) investors who can borrow say they have taken out a loan, according to Transamerica. Trouble is, 401(k) debt carries notable risks.
Say you're in the 28% tax bracket and you borrow $20,000 from a 401(k) worth $200,000. If your rate is 6% and your portfolio earns 6% a year on average during the four years you take to repay the loan, your 401(k) will end up where it would have been had you not borrowed. All you're out are your interest costs.
If you'd instead taken out a $20,000 homeequity line of credit at 5.4%, your 401(k) balance would wind up the same as in the example above. But you'd come out some $600 ahead because of the lower interest costs and because HELOC interest is tax deductible, says financial planner Jeffrey Pritchard, blogger at AllFinancialMatters.com.
While the 401(k) loan in this case wouldn't beat a HELOC, it isn't a terrible deal. And if your HELOC rate spikes, the 401(k) loan could look even better.
If things don't go that smoothly, a 401(k) loan can put a serious dent in your retirement prospects. Our example assumes you paid an interest rate equal to the return on the rest of your 401(k) funds. If the market rebounded and your 401(k) earned more than your rate, you'd have to include in your total costs how much your 401(k) could have grown but didn't.
Plus, while you pay off the loan, you may not bother (or be able) to invest in your 401(k), thereby losing your employer match. And your interest payments are taxed twice. You repay the loan with posttax dollars, then are hit again when you withdraw the money.
In this economy, a 401(k) loan is particularly risky. If you are laid off or switch jobs, you'll have between 30 and 90 days to pay back what you borrowed. If you can't, you'll owe income tax on the loan balance, plus a 10% penalty if you're younger than 59½.
Bottom line. Don't take the loan unless you absolutely must. You're borrowing against your financial future.
Do you (and your spouse) make more than $170,000 annually and worry about tax-efficient retirement planning? If so, send your name, age, occupation, income and questions, along with a recent photo, to firstname.lastname@example.org. We will be providing advice to a family in this situation in an upcoming article - and it could be you!