401(k) Plans and the 403(b)
Some “hardships,” as specified by the IRS, include the following:
Some plans permit employees to borrow money from their 401(k)s. It's extra paperwork for the employer, so some do not provide this option. And, some employers feel strongly that 401(k) money is retirement money and shouldn't be borrowed against, so they decline to provide a loan provision.
If permitted under your plan, you can borrow up to 50 percent of the total value of the account, up to $50,000. The loan must be repaid within a five-year period, or it becomes a withdrawal.
Many employees love the loan provision because it allows them to pay themselves the interest on the loan instead of a bank or credit union. When you repay the loan (with interest) the interest is added to your account.
There are, however, some problems with borrowing from your 401(k). If you borrow money and then leave the company, the loan must be repaid within a very short period of time.
If you decide to borrow from your 401(k) to buy a car, for instance, and then you leave the company for a better job, you must either borrow from someplace else to repay the loan, or the loan becomes a distribution, which is a taxable event.
These retirement plans are designed for retirement, and there are penalties if you take the money out ahead of time. Money you withdraw from a 401(k) is taxed at your current income tax bracket. And if you are younger than 59 and a half when you withdraw funds, a 10 percent penalty is due on top of the income tax liability.
Never take a loan from a 401(k) in which the interest would be deductible if borrowed elsewhere, such as with mortgage interest. Interest paid to your 401(k) plan is not deductible.
So if you borrow $8,000 for a car, leave the company, and can't pay your loan back within the required period, you'll pay income tax ($1,200 if you're in the 15 percent bracket), plus $800 penalty. Ouch!
A good reason to borrow from your 401(k) is to repay credit card debt. If you've racked up debt and you're paying 18 percent interest on your balances, you should consider borrowing from your 401(k) to pay off the cards. You'll pay a lot less interest every month on the money from your 401(k). Just make sure that you don't turn around and create new balances on the cards.
Another problem with borrowing from your 401(k) is that the loan is invested at a fixed rate as you repay it. It's similar to having your money invested in money market funds, and you'll realize a lower rate of return.
401(k) is an IRS code section that permits this type of retirement plan (a type of profit sharing plan). If you work for a nonprofit organization, such as a hospital, charitable organization, or university, you'll fall under the IRS code section known as 403(b). Look familiar? 403(b)s mirror 401(k)s, except for until recently, the investment vehicles could only be offered through an insurance company. Now, 403(b)s can be set up through mutual fund companies and you can roll a 403(b) into a 401(k) if you go from a nonprofit to a for profit company.
More on: Understanding Finances
Excerpted from The Complete Idiot's Guide to Personal Finance in Your 40s and 50s © 2002 by Sarah Young Fisher and Susan Shelly. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.
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