Why not borrow from my 401(k) for my daughter's college tuition, as there will be less to lose in this economic crisis?
-- Betsy Thomas
Borrowing from your 401(k) is almost always a big mistake. It may seem innocuous, since instead of paying back a bank loan, you're paying yourself. But you've lost the opportunity to earn further returns on the investments in your retirement plan. Borrowing from your 401(k) locks in losses on your investments and will likely miss out on any possible recovery in the stock markets. After investors overreact to bad news with panic selling, there is typically a big jump in the overall stock market followed by a lot of volatility and a more gradual slow recovery stretched out over several years. Making regular periodic investments in your retirement plan account gives you the benefit of dollar-cost averaging, which works best in such a volatile and uneven stock market. But when you borrow from your 401(k) your monthly payments go toward repaying the debt, not further investment, so your retirement plan account will fall further behind your goals. You will also miss out on your employer's matching contributions. A 401(k) also converts the pretax dollars in the retirement plan into after-tax dollars, since the loan payments are made with after-tax dollars.
You also need to consider the possibility that the economic crisis may put your job at risk. If you happen to lose your job because of the economy you will have to repay the loan immediately if you haven't reached age 59 1/2. If you are unable to repay the debt -- after all, you just lost your job -- you'll have to pay taxes on the "deemed" income plus a 10% tax penalty.
Federal education loans are usually a better deal than borrowing from your 401(k). The unsubsidized Federal Stafford and Federal PLUS loans are fixed rate loans, with interest rates of 6.8% and 8.5%. (The interest rate on the subsidized Stafford loan is lower for undergraduate students, due to a phased-in interest rate reduction. The interest rate on the PLUS loan is 7.9% at colleges that participate in the Direct Loan program.) The interest rate on 401(k) loans is a variable rate, typically Prime + 1% or Prime + 2%.
Up to $2,500 per year in interest on federal education loans is tax deductible (as an above-the-line exclusion from income, even if you don't itemize), while interest paid on a 401(k) loan is not tax deductible. The loan term on a 401(k) loan is up to 5 years, while federal education loans start off with a 10 year term that may be extendable to as much as 30 years in certain circumstances. The loan limit on the PLUS loan is up to the full cost of attendance, while a 401(k) loan is limited to half the retirement savings or $50,000, whichever is less.
Under no circumstances should you take a distribution from your IRA or a hardship withdrawal from your 401(k) to pay for higher education expenses. While this may avoid the 10% tax penalty, it will count as income and affect student aid eligibility in the next year. Your net after taxes and the financial aid reductions will likely be less than 40 cents on the dollar and perhaps much lower.