1/28/2011 1:33 PM ET|
When a 401k loan is a smart move
Borrowing quick cash from a 401k plan isn’t always a bad idea. These 6 questions can help you figure out if it's the right move.
Taking out a loan against your 401k is usually considered a big no-no by financial advisers.
After all, you miss out on the chance to earn returns on the money during the loan period, and if you suddenly lose or leave your job, you have to repay the loan within 60 days. You also miss out on the tax benefits, because you have to repay the loan with after-tax dollars.
But according to a recent paper (.pdf file) from the Michigan Retirement Research Center, people do use their 401ks to provide cash for purposes other than retirement, and that's not necessarily a bad thing.
Using a loan to pay off high-interest credit card debt, for example, can end up saving the borrower money. And the researchers point out that if workers know that a 401k loan is an option in case of emergencies, they might be motivated to funnel more money into their retirement accounts.
In a tough economy with tight credit markets, more workers are taking advantage of this option, with 11% of account owners taking out a loan in the past 12 months, compared with 9% a year earlier, according to Fidelity.
Just over two in 10 account owners currently have outstanding loans, and the average size of a loan is $8,650.
Still, 401k loans aren't a good idea for everyone. To decide whether a 401k loan is a good idea for you, consider these six questions:
What are your employer's rules for 401k loans?
Your company might not offer a 401k loan at all, and if it does, it probably comes with fees and restrictions. Interest rates on 401k loans are usually slightly higher than the prime rate, but again, companies have discretion and could charge a higher interest rate. (That interest gets paid back into the account holder's funds.)
Companies can impose their own limits, but federal law allows account holders to borrow as much as half of their account balance, up to $50,000. That means if you've saved $100,000, you can borrow a maximum of $50,000, but if you've saved only $50,000, you can access only $25,000. To avoid any surprises, make sure you know your company's policy.
How stable is your job?
One of the biggest risks with 401k loans is that you'll leave your job, either by choice or through a layoff. In most cases, you must immediately repay the loan, usually within 60 days, or face penalties.
"It's not uncommon for people to change jobs frequently, and it's important to know those tax consequences," warns Catherine Golladay, the vice president of education and advice at Charles Schwab.
Do you have a long-term plan?
Even though it might make numerical sense to take out a 401k loan to pay off high-interest credit card debt, it's not necessarily a good idea, says Golladay. Unless you have a long-term plan, you might find yourself racking up the same kind of expensive debt again, even with the 401k loan.
"You might see your credit card debt paid off, but then a year later, when an emergency comes up, you're back in the same cycle," she says.
Have you asked for help?
Your company or 401k plan provider might offer free counseling; at the very least, someone should be able to walk you through the plan's rules and fees.
Gerri Detweiler of Credit.com recommends talking with a credit counselor and possibly a bankruptcy attorney before using 401k funds to settle debt. She adds that while consumers should be careful, sometimes it can be smart to use a small amount of retirement money to settle high-interest-rate debt for a fraction of the total balance.
"This could put the debt behind them and help avoid either a lawsuit or a bankruptcy," she says.
Can you contribute to your 401k while you repay the loan?
If you stop making contributions to your retirement account when you take out a 401k loan, you'll be creating an even bigger hole in your retirement savings.
According to one study, a loan of $30,000 can cost borrowers as much as $600,000 in the long run if they also stop contributing to their accounts during the repayment period. (That calculation includes the cost of missing out on market gains.)
Are you in danger of bankruptcy?
During bankruptcy proceedings, retirement savings accounts are usually protected, but a loan against your 401k would not be. That means it would be safer to keep your money protected in your 401k if you are in danger of filing for bankruptcy.
The bottom line: The old advice that 401k loans are always a bad idea is too simplistic. Sometimes, taking a loan against your retirement account can provide a much-needed cash boost. But make sure you have a long-term plan and understand the risks involved so you don't deplete your retirement funds and make a costly mistake.
This article was reported by Kimberly Palmer for U.S. News & World Report.
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LostOnEarth very clearly illustrated why he/she is lost on earth. Even if someone had all their money conservatively invested in an S & P 500 fund before the meltdown, that someone would now be ahead today. While there are investment risks, steady conservative investing along with debt control is the only way Joe Sixpack can get ahead.
I am the millionaire next door
Someone (TNicos) is making the point that I have been making for quite some time. The advantage of taking a 401K loan as an alternative to financing through a bank or other lending institution can be realized if 1) the market is at it's peak and it begins treaded downward (your interest is paid to yourself rather than the lending institution, so you are still earning a return on your 401K during the downturn) or 2)if you are thinking of moving into a more conservative investment/fund in your 401K and expect a return less than the interest rate you would pay to a traditional lender by paying the interest to yourself (savings over paying same interest to lender) and receiving a higher rate of interest (say you expect a two percent return on the conservative investment and the rate on the load that you need is five percent from a traditional lender you have a net gain of three percent).
Nobody can time the market. The market does what the market is going to do. These strategies require you to make some judgments about which way the market is moving, so there is risk involved if you take the loan and the markets appreciate. If you take out a loan and the markets go up, you lose; it's that simple. Also, if you are severed from your employer, the tax implications if you are unable to pay back the funds are substantial (however, you an get a traditional loan at this point and save that tax liability and realize the possible savings for the duration of the loan to that point based on the scenarios outlined above).
As far as staying out of your 401K, I don't advise it. If your company has a match you should at least contribute to the maximum match amount. In most cases, even if the markets go down, you will be ahead when you are fully vested because the company match often exceeds the loss. If you are skeptical of the stock market you can invest your portion in very conservative funds and only put an amount equal to the company match in riskier investments. You have the tax savings of contributing to the plan, the satisfaction of knowing that your personal investment is at very little risk, and the hope that the company match portion invested in a riskier investment attracts a higher return.
JohnnyBGood, past performance is not an indicator of future performance. The sales men and industry propaganda have sold you a logic fallacy. Infinity cannot exist in a closed environment.
Think of the stock market as a beaker full of liquid money. If you keep pouring more and more money into the beaker it will over flow. The reason the stock market doesn’t overflow is because armies of neir-do-wells take money out almost as fast as you put it in. If more money is taken out then goes in the market goes down. If less money is taken out then goes in the market goes up. That is a simple description of market dynamics.
Market value is based on perception, air if you like; therefore it is based on the principle of ponzi. So long as Wall Street maintains the flow the illusion will hold up. Maintaining the illusion is necessary to keep the flow coming.
The baby boom has started removing their perceived value and that spells lean times for Wall Street if they continue to try to maintain flow control at current levels in competition with the boomers. I wouldn’t bet on it. If the Fed was not pumping the market up with inflation a major correction would have already shattered the illusion. The fundamentals haven’t changed and the Fed cannot keep it up forever.
Good luck in you gambling activities. I hope it works out for you.
Every person in the U.S. should do a calculation before even considering putting their money in a 401k. If you do not have adequate income and consequently savings to cover emergencies (health emergencies especially) then don’t contribute to 401k ever. In an emergency the first thing people tap into when they don’t have other savings is the differed income of a 401k. What starts out as good intentions becomes a cumulative current tax liability with an additional ten percent penalty tax. In the end the government ends up taking much more then they would have gotten had you just paid the tax.
Borrowing is not much different only someone beside the tax man is making out. It is a bad deal either way.
Our health care system is a giant wealth redistribution system. When you get sick and cannot work the monthly premiums will run through your saving quickly not to mention the co-payments. Until the inefficiencies of the 37 worse health care system in the world are addressed, what is the point deferring current benefits for retirement if the odds are you will not be allowed to use them for that purpose. Most of time people in the lower brackets are just better off not contributing. Pay the taxes in the current year and open a ROTH. Take out the principle when the need occurs.
As for those of us that have made the cut, our kids and grand children will not fair so well.
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