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Advantages and disadvantages of borrowing money from your 401(k) plan

Posted by Andrew Chan  October 19, 2010 01:00 PM

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Although the IRS generally allows loans to be taken from 401(k) plans, your employer may not allow it in their particular plan. If your employer does allow you to borrow from your 401(k) balance, there may be further restrictions. Loans from your 401(k) cannot exceed the lesser of 50 percent of your vested balance or $50,000 dollars and they usually need to be repaid within 5 years. In addition, employers may impose restrictions on the purpose of the loan. For example, some employers will only allow loans for unreimbursed medical expenses, educational expenses, first-time home buyers, and financial hardships. Be sure to check with your company or your company’s 401(k) plan administrator to confirm if you can borrow money from your 401(k) and, if so, under what conditions. Aside from these restrictions, you should keep in mind that there are advantages and disadvantages to borrowing from a 401(k) plan.

The main advantages of borrowing from your 401(k) plan include:
* No credit check - If your company allows the loan, it is usually easy to qualify for it without having to go through a credit check;

*Lower interest rates - The interest rates you repay the loans with are usually more favorable than commercial loan rates;

* The repayment of interest goes back into your account - You are paying yourself for the loan as opposed to paying a bank or credit union;

* Loan proceeds received are not taxable - The loan you receive is not considered taxable income unless you default on the repayment of the loan; and

* No early withdrawal penalty - As long as you do not default on the repayment of the loan, you are not subject to the 10 percent early withdrawal penalty if you take out a loan before age 59.5.

The main disadvantages of borrowing from your 401(k) plan include:
* The loan needs to be repaid - If you lose your job or leave voluntarily, you will usually need to repay the loan in full, right away, or be subject to income taxes on the outstanding balance and a 10 percent premature distribution penalty;

* Repayment is made with after-tax dollars - Each dollar you earn to repay the loan will have income taxes taken from it. That same dollar will be taxed again when you retire and withdraw your money from the 401(k). For example, if you are in the 25 percent tax bracket and you earn $100 dollars. After income taxes are taken from that $100 dollars, you will be left with $75 dollars to repay your loan. That same $75 dollars will be taxed again when you retire and withdraw the funds as a distribution; and

* Opportunity loss - By reducing your 401(k) balance you are losing the potential for that money to grow and earn interest over the long-term.

In general, taking a loan from your 401(k) is not a good idea for most people and not widely recommended. However, in certain circumstances it may be the only feasible option available. Keep in mind that 401(k) plans are setup with incentives to encourage people to create and maintain long-term savings for retirement.

This blog is not written or edited by Boston.com or the Boston Globe.
The author is solely responsible for the content.

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ABOUT MANAGING YOUR MONEY
Local finance professionals share insights and advice on issues such as budgeting, managing debt, and retirement planning.

About the contributors

D. Abraham Ringer is a CERTIFIED FINANCIAL PLANNER practitioner and a Financial Adviser with Morgan Stanley Global Wealth Management in Boston. He is registered in MA, NH, NY and several other states to which his articles are directed. For more information please visit www.morganstanleyfa.com/ringer
Financial Planning Association™ of Massachusetts has 900 members who specialize in the financial planning process. Many of its members engage in philanthropic pro bono work in their communities, recommend legislation, elevate public awareness, promote financial literacy, and advocate for sound economic and tax policies.
Odysseas Papadimitriou is the founder of CardHub.com, a credit card and gift card marketplace, and WalletHub.com, a personal finance site. He has more than 13 years of experience in the personal finance industry, and previously served as senior director at Capital One.

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