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Tuesday, February 24, 2009

Losing Money In Your 401K Through Borrowing

By David C Lewis

A majority of the population does not need an employer 401k. That said, some people are convinced that these things are not tax traps and that somehow everything will work out just fine.

If you are still on the fence about this, or you still like your traditional plan, you might as well get the most out of it. And, one of the best things you can do with your 401K is to leave it alone. Don't ever take a loan against your 401K if you plan on keeping it. Either cash it out or keep it in there, all of it.

First, when you take a loan from a 401k, it's not really a loan, per se. You are withdrawing funds from the plan. Since they aren't in the plan, they are not invested. The investments had to be liquidated so that you could have the money.

Bonds represent a fixed investment. The amount of the return is known in advance. You are lending either a corporation or the U.S. Government money in return for interest plus the return of your principal.

When you loan yourself money in a 401(k) though, you are simply replacing the interest you would already be receiving with interest payments from yourself. Remember, you have taken out money from your 401(k), and since it is not in your account while it's on loan, you are not earning interest in the stock, bond, or money market. You've simply substituted one borrower for another or changed the source of interest.

In addition, the interest payments you make back to your 401(k) are with after-tax dollars; and consequently, when you make a final distribution on that money, you will pay tax again on the money you paid back as interest.

Since this happens every time you take a loan against your employer 401k, you are really setting yourself up for a larger tax bite than you otherwise would have been subjected to.

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