Monday, September 6, 2010

Pitfalls Of Borrowing From Your 401(k) - IBD -

Need extra cash? Sooner than your local bank will approve a loan? With much less paperwork? At a far lower interest rate? No matter how crummy your credit score is?

Chances are it's yours for the asking. Most plans let members borrow from their regular 401(k) accounts.

The portion of members of plans run by Fidelity Investments borrowing from their accounts in the 12 months ended June 30 hit 11.1%. That's the highest since Fidelity began to keep count about a decade ago.

Loans are cheap, often prime plus one percentage point, or 4.25% now. That compares with 7.4% for a home equity loan and 10.4% for low-interest credit cards, says

And this type of borrowing does not hurt your credit score the way other loans and credit cards can.

But tapping your 401(k) in this way is not always a good idea. It can create long-term problems for your retirement.

"Loans can help people meet urgent financial needs," said Judith Ward, a senior financial planner for T. Rowe Price. "But generally people are better off if they don't take that money out of their accounts."

You can borrow from your account for basically any reason, so long as your plan permits loans. Your plan may also limit loans to certain purposes, such as unreimbursed medical expenses.

The problem: loans usually amount to robbing Peter to pay Paul.

"Borrowed money is not at work building for your retirement," Ward said "That's a lost opportunity, which you never get back."

A second potential drawback involves repayment. Suppose you borrow when the market is down. If you replace those shares after the market recovers, you will pay more for those shares, or end up with fewer shares.

A third downside stems from taxes. Money you borrow was put into your account with before-tax dollars. You paid no taxes on them yet.

But you repay the loan with after-tax dollars. Once that money is back inside your traditional account, you will pay taxes on it again — plus its earnings — when you withdraw it during retirement.

It's a double-tax whammy.

Taxes And Penalties

Other aspects of repaying a loan can be hassles.

You've got to pay back your account within five years unless your plan sets a shorter limit. An exception is if the loan is for buying a principal residence. Then you'll have more like 10 years.

"So don't borrow unless you can pay it back on time," Ward said.


Pitfalls Of Borrowing From Your 401(k) - IBD -

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