401(k) LOANS: PROCEED WITH CAUTION

 401(k) LOANS: PROCEED WITH CAUTION

As funds begin to accumulate in your 401(k) and other qualified retirement accounts, you may feel the need to access those dollars for emergencies or to make a major purchase.  As mentioned in a previous article, taking money out of those accounts before a certain age can be very costly because of early withdrawal penalties and taxes due.  For workers participating in a 401(k) or 403(b) plan there may be another way.

 BORROWING FROM YOURSELF.

You may be eligible take out a loan against these funds and have the use of that money, but be aware that this type of arrangement has financial consequences that carry risks.  First, a little bit of good news.  When you take out a 401(k) loan you are effectively "borrowing money from yourself" so no credit check should be required.  Next, you will probably get a much lower interest rate than those charged for regular loans and won't face high upfront fees or closing costs.  Not having to face traditional loan underwriting standards (and a denial of your application) is welcomed news for many families that now find themselves with damaged credit.  Beyond these advantages, be aware that a loan of this type has restrictions and pitfalls.

LIMITS ON 401(k) LOANS.

There can be limits as to the amount that you can borrow, the terms and even the availability of getting the loan.  Some rules are set by the government and some by your employer.  I'll not try to cover all the bases, but here are a few general requirements:

*  Limits on how much you can borrow.  You are restricted to one-half of your balance that you have contributed, but not more than $50,000.  Notice that employer contributions are excluded from this calculation.  Your employer/plan administrator may have additional rules and borrowing limits.

*  Limits on the loan term.  You must pay back the loan in five years or less.  Exceptions are made if you are using the funds to purchase a home.

THE DOWNSIDE RISKS OF THESE LOANS.

* If you get fired or leave your job, the loan is due and payable.  Upon termination of your employment with your current company, you'll have to pay back any outstanding balance within 60 days.  Failure to do so will trigger early withdrawal penalties and taxes due.  You could find yourself unemployed and saddled with a huge current tax bill.

* Double taxation.  You pay back your 401(k) loan with after-tax dollars.  Then you pay taxes on it again after you retire and draw the money from your account.  Uncle Sam loves you.

* Unplugging a productive asset.  All of the time that your retirement money stays out of your account is time that your money is not working for you.  In a down market this isn't such a big deal, but didn't you invest on the assumption that these funds will grow over time?

IS A HARDSHIP WITHDRAWAL A BETTER OPTION?

If you are facing an emergency and need to get access to your money, perhaps you should consider a hardship withdrawal instead of a loan.  Under certain conditions and subject to your employer's rules you could request your funds be released under a hardship arrangement. For an excellent summary of hardship withdrawal policies, see the following site:

                 http://beginnersinvest.about.com/od/401k/a/aa122104a_3.htm

 Taking money from a qualified fund before you retire may be unavoidable, but it always should be approached with caution.  Always seek the advice of a trusted counselor before making the move.  

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