Some 401(k) plans allow loans, but borrowing isn't a wise idea


I need to know exactly what happens when you have a 401(k) loan. How is this supposed to be repaid, and how are we supposed to be told what is happening with our 401(k)?

-- M. F., Cranston, R.I.

A 401(k) plan is a retirement savings plan offered through your employer. In general, there's no immediate income tax on the money you contribute or on the money your account earns. The only time it's taxed is when you withdraw it.

Because these plans are set up as long-term savings plans, you typically don't have easy access to the money in your account. You generally can get the money only when you retire or change jobs.

But the law allows 401(k) plans to offer loans to plan participants. Many plans do, but some don't, said Dee Lee, author of "The Complete Idiot's Guide to 401(k) Plans" (Macmillan; $17.95).

To find out whether yours does, and how it works, check the booklet or brochure your company gives you. (It's technically known as the "summary plan description," and the law requires that your company give you one.)

You generally may borrow between $1,000 and $50,000, or half of your account balance, Lee said. You pay back the loan on a fixed schedule, through payroll deduction. Plans typically require you to pay back your loan in five years.

But there are potential problems. For instance, if you lose your job, you must pay off the balance immediately. If you don't, it'll be considered a withdrawal. As a result, you'll have to pay income tax on it, and you may face a possible 10 percent penalty, too, said Lee, president of Harvard Financial Educators, of Harvard, Mass.

In addition, you'll miss a chance for your money to grow inside your account, toward your retirement. In other words, the money you borrow will earn only the rate your plan charges on loans, not the potentially higher rate the money could earn if the money were in your account all the while. Overall, "Borrowing is not a good idea. Don't do it; it's not prudent," Lee said.

What if you need the money? Look elsewhere. For instance, if you own a home, think about getting a home equity line of credit, she said. If you need the money to pay for college, consider a college loan. "To me, a 401(k) or 403(b) plan or an IRA are sacred cows: You don't touch them until you retire," Lee said.

Copyright © 2021, The Baltimore Sun, a Baltimore Sun Media Group publication | Place an Ad