Borrowing against a 401(k) plan can be prudent


NEW YORK -- If you're saving money in a 401(k) retirement plan, and suddenly find that you need some cash, you may decide to take a loan against the plan. You have to make regular repayments. But instead of paying interest to a bank, you pay it to your 401(k) account. So you're paying interest to yourself.

Normally, you'd ask the plan for a loan and arrange to repay through payroll deduction. But Banc One, based in Columbus, Ohio, is promoting a new Visa card for tapping 401(k)s. The bank expects to test the card this fall in the Indianapolis area.

You couldn't telephone Banc One and get a card for yourself. Employers would have to offer it as part of their plan. Banc One thinks that more workers would contribute to a 401(k) if there were an instant way to borrow the money back.

So should you borrow against your 401(k) if the plan allows it? If so, is it smart to use a 401(k) credit card?

As long as the loan makes sense in the first place, there's normally no harm in borrowing against your 401(k). You shouldn't tap this important nest egg for everyday spending or a vacation. But it's an acceptable source of money for essential spending such as college tuition, a down payment on a home or expanding a business.

If you borrow directly from the plan, you'll generally pay 9 percent to 11 percent interest today. That's a reasonable return on investment for your 401(k). Most 401(k) loans must be repaid over five years in regular monthly or quarterly installments. If you borrowed to buy your principal home, you can pay over 10 to 30 years, depending on the plan.

Borrowing can't hurt the plan if the interest you pay is at least as much as your 401(k) was earning on its other investments (so the plan won't be losing any money) and if you repay.

But the interest often isn't tax deductible. So you pay taxes on it twice -- once when you earn the money that you use to pay interest into the plan and again when you retire and start making withdrawals, says Margaret-Ann Cole of the consulting firm Kwasha Lipton in Fort Lee, N.J. (Interest is deductible only if you borrow the employer's contribution, not your own, and borrow for a deductible purpose like starting a business.)

A home-equity loan would be better than a 401(k) loan, because of its tax-deductible interest.

You normally can borrow up to 50 percent of your vested assets in your plan. (The Visa-card plan allows 40 percent, up to a maximum credit line of $10,000.) If you quit your job or lose it, however, you generally have to repay right away. Otherwise, the loan will be treated as a withdrawal, forcing you to pay income taxes on the money plus a 10 percent penalty if you're under 59 1/2 .

What about Banc One's 401(k) Visa card?

You get the money faster than if you use the plan's loan procedures. You can borrow small amounts. The rate of interest is probably less than you'd pay on loans against a credit card.

But it costs more than if you used the plan's traditional borrowing procedures. With Banc One's Visa-card loan, you'd pay your plan the prime interest rate (8.25 percent today), so the plan earns less than if you had borrowed the usual way. On top of that, you pay 3 percent to 4 percent to Banc One.

Furthermore, you have to write your own check each month rather than repay by payroll deduction. That makes it easier to default than if you were paying by payroll deduction. Defaults trigger taxes on the outstanding loan.

A 401(k) credit card poses no danger to the prudent. But it's a serious risk to credit-card abusers.

Pub Date: 8/05/96

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