401( k) loans can work out, but watch for pitfalls

Q. Should I take out a 401( k) loan to pay my child’s tuition?

A. Typically, you can borrow from your 401( k) at a percentage point or so above the prime rate, which is currently 3.25%. That’s a low rate.

When you’ve paid off your 401( k) loan, it’s back in your 401( k) account, instead of in the bank’s coffers. And in many cases, you can continue to contribute to your 401( k) while repaying your loan.

What’s not to like? First of all, if you lose your job before you repay your loan, the IRS will view the loan as an early withdrawal. You’ll owe 10% on the amount left on your loan, as well as ordinary income taxes on the amount you haven’t repaid. That will turn a cheap loan into a very expensive one.

Second, by taking out money from your 401( k), you’re reducing your balance — which, in turn, reduces the potential return from your 401( k).

“You’re losing investment opportunity on that money,” says Jeff Leventhal, managing director at HighTower, a Bethesda, Md.- based advisory firm. If you’re short of money at retirement, you’ll either have to work longer or lower your standard of living to make up the shortfall.

In most cases, Leventhal says, you’re better off having your child use student loans. Most loans allow the student to defer payments while in collage, and offer relatively low interest rates when payments begin. “There is more flexibility with student loans if the student qualifies,” Leventhal says.