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Should I take a loan from my 401(k) to pay for my children’s college education? Or perhaps my IRA?


Plan B is definitely out. You’re not allowed to borrow from an IRA. Any money you take out will be deemed a distribution. The amount you withdraw will be taxed as ordinary income, although if it’s a Roth IRA you won’t be taxed on the part that represents your original contributions because Roths are funded with after-tax dollars. To make matters worse, unless you are older than 59 and a half, there will be a 10 percent penalty on top of the income tax.
Borrowing from your 401(k) is allowed as long as your employer permits it, which many do. It’s considered unwise for several reasons, however, some more valid than others. First off, the account is there for retirement, and using money other than for the purpose it is intended is a bad habit to get into and a hard one to break. What makes borrowing from a 401(k) especially dangerous is that if you miss payments for 90 days, the Internal Revenue Service will consider you in default and count the unpaid balance as a withdrawal; you’ll owe tax and, again, a 10 percent penalty.
Some critics of 401(k) loans like to point out that the money used to pay them back is taxed twice; the payments come out of money that has already been taxed, and it will be taxed again when it’s withdrawn in retirement. That’s true – sort of. If you borrow from a commercial bank instead of your 401(k), the payments are made with after-tax dollars, too, so in that sense it is no different from a 401(k) loan.
On the pro side, a 401(k) loan, which can be for up to $50,000 or half of the value of your account, whichever is less, essentially involves borrowing from yourself and therefore paying yourself back.. The interest rate will be lower than on a commercial loan and the interest you pay will go back into your account, so you’re paying yourself instead of a bank. If you can borrow from an alternative source at a low interest rate, such as a home-equity loan, then that’s probably a better option than tapping your 401(k). But if that’s not possible, then a 401(k) loan that you’re 100 percent sure you can keep up payments on is not the end of the world.
One other thought: If you must borrow from your 401(k) to pay for your children’s college and they’re not going to enroll for at least a few years, then start 529 plans for them. These are government-approved accounts that are intended to pay for education expenses and offer some tax breaks, although not as generous as the ones for 401(k) plans. You’ll still have to repay the loan, but at least the amount you borrow will be put to work in the most tax-efficient way.

-Conrad de Aenlle