By David Compton / guest columnist
May 04, 2008 12:07 am
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Cash-strapped individuals may see a loan from their 401(k) as a tempting way out of a crisis. But tapping your nest egg prematurely can be a very expensive option.
On the surface, borrowing from a 401(k) seems like a good way to solve a financial dilemma. After all, it’s your money; why not use it? Such loans usually require no credit check, and the interest rate is normally favorable.
But there are some problems with this approach. First, any funds that you borrow cease to be invested. This could have a profound effect on long-term growth in your retirement fund. Also, if you default on the note, the loan balance is treated as a taxable distribution, and if you are younger than 59?, there can be an additional 10 percent penalty.
The problems don’t stop there. If you lose your job while still owing on the 401(k) loan, you will typically have only 30 to 90 days to pay it back. What’s more, the interest you pay on the loan is not tax-deductible, unlike interest paid on a home mortgage. And by withdrawing funds from your 401(k), you are depleting an asset that is safe from creditors.
When your financial situation leaves you no other choice but to borrow from your 401(k), there are a few things you can do to make the situation better. Consider withdrawing the funds from the cash or fixed-rate portion of your plan’s portfolio. This may leave higher-earning investments at work. Try to pay off the loan as quickly as possible, and continue making regular plan contributions in order to take full advantage of your employer’s match.
David Compton is a Certified Public Accountant with offices in Meridian and Birmingham, Ala.
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