Retirement savings vs. paying off bills

Q: Should I borrow from my 401(k) plan at work to pay off my mortgage? A: This is a questions I am frequently asked and, in most cases, my answer is no. But depending on your specific circumstances, it may be an option. Let’s discuss some of the pros and cons for everyone’s benefit.

Is there anything your 401(k) plan can’t do? It allows for tax-deferred earnings in traditional accounts. Traditional plans allow you to make contributions in pre-tax dollars, helping to reduce your taxable income. It even offers a menu of professionally managed investments from which to choose.

But there may be another feature of your 401(k), or a similar retirement plan, that you haven’t considered: You may be able to borrow money from your account to fund other financial priorities, such as paying for college tuition, paying off high-interest credit cards or even paying off the mortgage on your home.

Read the rules first

The IRS currently allows you to borrow up to 50 percent of the total vested assets in your account, up to a maximum of $50,000. There may be loan minimums and certain other restrictions, depending on your plan’s specific rules.

Here’s how a 401(k) loan works: The 401(k) sponsor (your employer) sells a portion of the plan investments from your account equal in value to the loan amount. If your 401(k) account is invested 70 percent in equity investments and 30 percent in a fixed-income investment, the assets will be sold in the same proportions. The loan repayments you make will be reinvested in whatever your current allocations are to be.

Money borrowed for most purposes must generally be repaid within five years. Specific terms of the loan — frequency of payments and the interest rate — will be determined by your company, which may allow you to make payments on a loan through payroll deduction. IRS rules require payments to be made at least quarterly.

Weigh the pros

For some, the primary attraction of a 401(k) loan is the simplicity and privacy not generally associated with a bank or finance company. And unlike banks and other sources of loans, there is no need to fear being turned down for the money when borrowing from a 401(k) plan.

Another benefit may be competitive interest rates, which are generally tied to the prime rate. Keep in mind, however, that unlike the interest associated with some other types of loans — such as your home mortgage — this interest is not tax deductible.

… and the cons

While these advantages may make a retirement-plan loan appealing, there are several other points you should consider. First, if you are separated from the company through which you took the loan before you fully repay the money, you may be required to pay the balance within 30 days or pay federal income taxes on it. You could also be charged a 10-percent early withdrawal penalty by the IRS.

Second, be aware of the potential “opportunity cost” of borrowing from a 401(k) plan — the cost of any potential return you’ll miss out on if the interest rate on the loan is lower than the account’s rate of return. For instance, if you borrow money from an account earning 10 percent and you pay 7-percent interest on the loan, you miss out on a potential 3-percent return on the balance of the loan. Over time, the missed earnings can add up and result in a lower balance in retirement savings.

Also take note of any fees charged for retirement-plan loans by your company. In addition, some companies set deadlines for applying for loans and may take up to two months to process the application.

Last, but certainly not least, one of the most compelling reasons for not tapping your retirement account, particularly if you are experiencing financial stress, is that current law protects such assets from creditors in bankruptcy proceedings.

So, in the final analysis, even though you may be feeling pressured to pay off your mortgage, think long and hard before turning to your retirement plan. You could end up enhancing one area of your financial life at the expense of another. As always, please speak with your financial and tax advisors in more detail about your specific situation before making a final decision.

Jeremy Gussick is a financial advisor with LPL Financial, the nation’s leading independent broker-dealer.* Jeremy specializes in the financial planning needs of the LGBT community and is active with several LGBT organizations in the Philadelphia region, including the Delaware Valley Legacy Fund, the Greater Philadelphia Professional Network and the Independence Business Alliance. Out Money appears monthly. If you have a question for Jeremy, contact him at [email protected].

This article was prepared with the assistance of Standard & Poor’s Financial Communications and is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor or Jeremy Gussick if you have any questions. LPL Financial, Member FINRA/SIPC. *Based on total revenues, as reported in Financial Planning Magazine, June 1996-2009.