Think Twice — It Could Cost You
To help finance their children's education, some parents take out loans from their 401(k) plans. While that may seem appealing, it may be better to have your child take out a student loan instead. Here’s why.
401(k) Loans Reduce Your 401(k) Earnings
If you borrow from your 401(k), you limit the potential growth of your retirement assets. For example, if you take out a loan for $10,000 from your 401(k), that $10,000 won't be earning any interest for you during the life of the loan. And you’ll lose not only the accruing interest amount, but also any compound interest.
The loss of these additional earnings in your 401(k) could mean that you might not have enough funds when you retire. In that event, you might end up having to depend on your child to help support you.
This places a burden on your child, which is the very problem you were trying to avoid by taking out the 401(k) loan in the first place. If your family decides to do this, make sure you all understand the possible future obligations that this decision implies.
Pretax vs. After Tax
The contributions you made to your 401(k) were in pretax dollars. However, if you take out a loan, you pay yourself back in after-tax dollars. Once you take out that $10,000 loan, you need more than $10,000 in salary to pay it back (since taxes are withheld from your salary), which is a significant hidden cost.
Job Loss Issues
Some plans require an employee who loses a job to pay back any 401(k) loans immediately. If you can't repay the loan, then it is considered income, and you must pay taxes on it. If you are under 59 1/2, you also have to pay an early withdrawal penalty of 10 percent of the loan amount.
Your Child's Debt Burden
While it's difficult to see your child graduate with student loans, keep in mind there is a longer time frame to pay off these loans. If your cash flow allows, you can always help make loan payments after graduation.
This article is intended for informational purposes and is not intended as tax or financial advice.