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  • Borrowing

    Posted on March 16th, 2011 Patricia No comments

    Is it ever a good idea, financially speaking, to borrow money from a 401(k)?

    You’ve asked an excellent question. Here are the basics:

    About 75% of all employers allow employees to borrow up to 50% of their vested balance or $50,000, whichever is less, from their 401(k) plan.

    You can’t borrow just to have some mad money on hand. You can borrow only to pay for emergency medical expenses, to purchase a house, to pay for college tuition and a few other specific “hardships.” Ask your benefits officer for precise details.

    You must pay back the loan within five years, with interest. The interest is usually the prime rate plus one percentage point. However, if you use the money to purchase a principal residence, you might get as long as 15 to 20 years to repay the loan. Again, ask.

    There are several definite pluses to borrowing from your 401(k):

    1. You’re borrowing from yourself, rather than from a bank. This means you’re paying yourself back, not an institution.

    2. The money you borrow is not taxable income because you must repay the loan, usually through monthly or quarterly payroll deductions.

    3. Because repayment is done through payroll deductions, you won’t miss a payment nor will it hurt quite as much as if you had to sit down and write out a check every month.

    4. The interest rate on the loan is generally lower than if you borrowed from a bank.

    That’s the good news.

    But Cash Flo wants you to be fully aware of the bad news:

    1. Borrowing means you’re depleting your account. In other words, there’s less money in the account that will benefit from compounding and investing.

    2. If you leave the company, or if you’re laid off, in the five-year period before you pay back the loan, you must cough up the ENTIRE BALANCE within 30 days. If you don’t, you’ll have to pay income tax on the amount you still owe PLUS a 10% penalty for early withdrawal.

    $$$TIP: If, for some reason, you must borrow from your 401(k) plan, take out only as much as you can comfortably repay. This is your retirement plan; it should be used only for serious needs.

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