Making More Hay Out of a 401(k)
QUESTION: I have been trying to put together some money to invest in the stock market, but every time I scrape together a few hundred dollars, something unexpected comes up. Last month, it was an unexpected tax payment to the IRS. The only savings I have are two retirement plans: an IRA and a 401(k) plan at work. I know I can’t withdraw money from the IRA without a penalty and a tax payment, but is there any chance I could withdraw some money from my 401(k) plan?--A. M.
ANSWER: Most employers offering 401(k) retirement plans are very strict about letting employees withdraw money from these accounts. Some permit withdrawals for the purchase of a first home or to finance a child’s college education. But most will let you dip into your account only in an extreme emergency.
But don’t get discouraged yet. There are two other ways to employ your 401(k) plan for the type of transaction you’re considering. Borrowing against your savings is one possibility. Another is instructing your employer to invest your savings or your employer’s contributions or both in stocks.
Let’s discuss the second option first, since virtually all employers with 401(k) programs give participating employees this choice. The 401(k), so-called because of the Tax Code section where its rules are detailed, is a tax-deferred retirement plan funded with employee wages and matching employer contributions. Employees get to choose how much of their wages to contribute to this plan--usually to a maximum of 6% of their salaries--and how the money will be invested. The investment options vary from company to company, but most offer a choice of company stock, stock mutual funds, cash in the bank or a combination of the three.
One way to capitalize on the bull market, then, is to simply ask your employer if company stock or mutual funds are options available to you and, if so, to have your savings invested accordingly.
If you’re interested in really playing the market and calling the investment shots yourself, though, this option is less than ideal. Very few companies now permit 401(k) participants to direct the investment calls themselves. Instructing your employer to invest in equities is basically the only role you have. There is some talk among corporate employee-benefit specialists about broadening employees’ powers over the investment of their 401(k) money. But so far, it is just in the discussion stages--which brings us to your other choice.
Although there are some restrictions on borrowing money from your 401(k), employers are far less strict about borrowing than about withdrawing the funds with no intention of replacing them. A survey of 200 401(k) plans last year by Hewitt Associates, a consulting firm specializing in employee benefits and compensation issues, found that about a third will lend employees money with their 401(k) savings as collateral. And only about a dozen of the plans require the borrower to prove that they need the money to resolve an “extreme hardship.” In other words, if your employer will let you borrow against your 401(k), you probably won’t have any problem justifying a loan for the purchase of stocks.
Employers, however, usually do restrict the frequency and size of your borrowings. A good rule of thumb, Hewitt says, is that you’ll have to borrow at least $1,000 but no more than $10,000. Some firms allow employees to borrow against their savings only and not against the employers’ contributions, while others permit borrowings against all of the employee’s vested funds.
Generally, any money borrowed from a 401(k) must be paid back within five years. The biggest exception to that rule comes when the money is used to purchase or make improvements on a principal residence. In that case, the borrower has 10 years to repay the debt.
Why borrow from your 401(k) instead of simply discontinuing your 401(k) contributions and pumping the money into the stock market instead? You get two tax breaks by borrowing, neither of which you would receive otherwise. First, the wages you earmark for the 401(k) aren’t taxed until you retire and begin using the money. And second, you can take a tax deduction for the interest payments that you make on the loan.
Be sure to do some comparison shopping of interest rates and terms before you go the borrowing route. Because the employer loans are backed by vested 401(k) savings, you usually can get a slightly better deal by borrowing from your 401(k) plan than by turning to your friendly banker or credit union. But with the financial industry becoming increasingly rate competitive, that’s not always the case.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Los Angeles Times, 780 Third Ave., Suite 3801, New York, N.Y. 10017.
