A 401k is a
company sponsored retirement plan. Employees are
typically provided with a group of funds from which to
invest. The investments are made on a pre-tax basis and
are allowed to accumulate tax deferred. Individuals can
begin withdrawing funds at the age of 59 ½. Any money
that is distributed prior to that point is subject to a
10% penalty. However, in some cases it is possible for
people to temporarily borrow money from their 401K
accounts without incurring a penalty.
Many plans
allow investors the option of borrowing from their
accounts provided certain stipulations are met. First,
the money which is borrowed can not exceed the lesser of
$50,000 or 50% of the account balance. The loan must be
paid back within 5 years, and a payment must be made at
least once a quarter. Next, the individual must pay
interest back into his account.
These loans
provide several advantages and disadvantages which are
listed below:
Advantages
- Provides access to significant
amounts of money. The exact amount is dependant on the
level of funds in the account at the time of the
loan.
- Participants
pay interest to themselves. If you have to pay
interest, then it is better that it goes to you then
to a bank.
- Borrowed
money remains tax deferred. This remains the case as
long as all of the conditions of the loan are met.
- May be
easier to obtain than conventional loans for
individuals with less then perfect
credit.
Disadvantages
- Threat of
penalty. If the conditions of the loan are not met
(i.e. not paid off in 5 years, or quarterly payments
not met) then the money is considered a distribution
and a 10% penalty is accessed. In addition the money
becomes taxable income.
- Loan becomes
due if an individual loses his job. If a person quits
or is fired then they must pay back the loan
immediately. Failure to do so will result in a 10%
penalty and the money from the loan will automatically
be considered taxable income.
- Money may
grow at slower rate. The interest that an individual
pays back into his account may end up being less than
what would have accumulated originally.
- Interest
payments are not tax deductible. This money is coming
from after tax dollars.
Borrowing money
from a retirement plan is not generally a good idea. It
exposes individuals to potential penalties, as well as,
placing the rate of growth in jeopardy. There may be
some isolated exceptions where a loan of this type would
be beneficial, but in general, people should leave their
retirement money in place for its intended
purpose.
