Borrowing from a 401(k)

Borrowing from your 401(k) can hurt you over time, she says. The employee is losing the compounded interest. Even worse, many people stop making new contributions during the payback period.

Too often, Hess says, 401(k) plans become a "revolving door with the same employees taking money out over and over again, many with multiple loans."

Disadvantages of 401(k) loans:

  • You're paying the loan back with after-tax dollars; the interest you pay is not tax-deductible.
  • Should you default on your loan, the unpaid portion of your loan will be treated as a distribution by Uncle Sam. It will be subject to ordinary income tax and the 10 percent early withdrawal penalty if you're under age 59 1/2.
  • Should you lose your job or leave the company, most employers require borrowers to pay back their 401(k) loans in full, usually within 60 days.
  • If you are unable to pay up, the unpaid portion of your loan will be treated as a distribution, complete with taxes and penalties.

Like Hess, VanDerhei encourages retirement savers to explore all their options, including home equity loans, before tapping into their 401(k)s.

How a 401(k) loan affects long-term savings

A 30-year-old man with an annual income of $40,000 (assuming 3 percent annual raises) and a 401(k) balance of $45,000 contributes 6 percent per year to get his full employer match (3 percent).

Assuming a 7 percent investment return in his 401(k), his nest egg will grow to $1,188,091 by age 65.

If he borrows $8,000 at a 6.75 percent interest rate, however, and pays it back over five years without contributing to the plan during the payback period, his ending balance falls 14 percent to $1,020,845 at age 65.

Source: Hewitt Associates.

"Depending on the terms, it might be better to take out a home equity loan or you may have a life insurance policy with cash value to borrow against," he says.


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