Considering 401(k) Withdrawal? Don't!

Thursday, 24 Jul 2008 | 5:18 PM ET
OTM Web Extra
CNBC's Carmen Wong Ulrich helps viewers manage their personal finances.

When the market's down huge like it was Thursday, it might seem tempting to think about changing your 401(k) loan into a withdrawal. But don't. Watch the video to see why Carmen says now is actually when you should be adding to your nest egg.

Carmen - - -
Many discussions on this subject ignore the double taxation factor. Repaying a 401(k) loan is done with after-tax dollars. When that money is removed in retirement it is taxed again. Here is an example for someone whose total income tax (federal and state) is 30%:

Amount borrowed: $40,000
Amount repaid at 8% (4 year repayment): $48,000
Income taxes paid on repayment dollars: $14,400
FICA paid on repayment dollars: $3,672
Total cost of repayment: $66,072

If one repays in the maximum allowed time of five years, interest costs increase.

If one is not repaying from income within the maximum FICA tax bracket, that cost goes down; however, income taxes will increase to at least partly offset for higher incomes. For very high income tax brackets the taxation of the repayment dollars will be higher than illustrated.

When these (already taxed) repayment dollars are withdrawn, they will be taxed again at the then current tax rate.

If tax rate in retirement is the same as the rate when the loan is being repaid, the effective interest rate on the loan is more than 24%, 8% to the 401(k) account and more than 16% to the taxman. --John B. Lounsbury, PhD, CFP

Posted on: 28 Jul 2008 12:04 P.M.