Armchair Millionaire Community Bulletin: Borrowing from the Bank of 401(k)

Because of the many drawbacks associated with it, borrowing from your 401(k) should be a source of last resort. Use it only if you absolutely must.

New York, NY (PRWEB) March 22, 2005 -- According to the Employee Benefits Research Institute, about one in six employees eligible to take out a loan from their 401(k) plan has a loan outstanding. However, the fact that so many do it does not necessarily make it a good idea. This story from the Armchair Millionaire community points out some of the disadvantages of borrowing from your 401(k):

"I borrowed from my 401(k) when my daughter got married. I sometimes regret it now--surely she would have married anyway, but with a less elaborate wedding. I love my child, and the wedding was very nice, but I will be in debt for the next 4.5 years and my account is half the size it used to be. Previously I was contributing $400 per month pre-tax; now I am just making post-tax loan payments. I wish my employer had not put loan provisions in the plan!"
- Linda

The idea of borrowing from yourself and paying yourself interest--looks great at first glance. But consider that while you're paying yourself interest, you're also losing out on the interest or returns that your money would have earned if you'd just left it alone. This can easily wipe out any net benefit you might have received, especially when you consider that your 401(k) investment returns are tax-deferred and that your 401(k) loan interest is not tax deductible.

So before you jump into that 401(k) loan, evaluate the pros and cons carefully. My guide will help.

The Armchair Millionaire's Guide to the Pros and Cons of 401(k) Borrowing

The pros:
• It's quick and easy. Most employers make it very easy to take out a loan against a 401(k), with little or no paperwork and a quick turnaround. And when you pay it back, your principal and interest payments will be automatically deducted from your paycheck and put into your 401(k) account.
• The terms are straightforward. You can usually borrow up to $50,000 or one-half of your contributions and vested employer contributions, whichever is less. And you typically have to repay the loan within five years.
• You'll get a decent interest rate. Rates are quite competitive, usually prime rate plus 1 percent.

The cons:
• You can miss out on the growth of your money. Compounding returns are the magic ingredient for building your retirement fund, and you lose them when you take your money out for the loan. If you stop making contributions while you're paying back the loan - something many people do - you'll lose out even more.
• You'll end up paying more tax. You make your loan payments with after-tax money, but when you take distributions from your 401(k) upon retirement, you'll still owe tax on all that money. This means you'll end up paying taxes twice on the money used to pay back your loan.
• You could be in trouble if you leave your job. If you quit or are fired, you'll have to pay the loan back in full immediately - usually not a great situation when you've just left a job.
• You'll be in even more trouble if you default. It's going to hurt if you fail to repay your loan. The unpaid balance will be treated like a distribution from your plan, meaning you'll have to pay income taxes on the amount and, in most cases, a ten percent early withdrawal penalty.

The Bottom Line: Because of the many drawbacks associated with it, borrowing from your 401(k) should be a source of last resort. Use it only if you absolutely must.

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Lewis Schiff founded the Armchair Millionaire Web site in 1997. His first book, The Armchair Millionaire, was published in 2001. Schiff's newest report, "How to Know When You Are Rich," is now available at www.armchairmillionaire.com.

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Lewis Schiff
Armchair Millionaire
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http://www.armchairmillionaire.com