Can You Borrow From Your Mutual Funds?

A mutual fund is simply a pool of money into which a number of investors contribute. They hire a professional money manager to invest on their behalf. The fund manager typically invests in stocks, bonds, cash equivalents such as money markets, and occasionally in options and real estate investment trusts (REITs) according to the fund's investment objectives. Investors can purchase mutual funds within tax-advantaged retirement accounts, or hold them outside of these accounts. Each method has advantages and disadvantages.

Borrowing Securities

In general terms, you cannot borrow from a mutual fund directly, in most cases. You can, however, purchase a mutual fund through a brokerage account and open a margin account. In a margin account, you can borrow money from the brokerage, using your mutual funds as collateral for the loan. However, if the fund's value falls, you may be subject to a "margin call," which means the brokerage company will require you to quickly deposit cash in the account to bring the account value back up, or it will sell your funds to cover the debt. This may result in an unwanted tax liability for you.

Borrowing From 401k Plans

Some 401k plan sponsors allow you to borrow from 401k plans at work. When you borrow from a 401k, you are not taxed on the distribution, but you are obligated to pay yourself back over time. If you lose your job, however, you will have 60 days to repay the loan in full, or the Internal Revenue Service (IRS) will deem the entire loan balance to be a distribution and charge you income tax, plus a 10 percent penalty for early withdrawal if you are under 59 and one-half years old.

IRAs

You may not borrow from funds held in an individual retirement arrangement (IRA), nor may you pledge one as a collateral for a loan, even if you hold an IRA with a brokerage that generally allows borrowing on margin.

Withdrawals from Mutual Funds

If you hold your funds outside of a tax-advantaged retirement plan, you can simply withdraw funds as needed, rather than borrowing them. You will be liable for capital gains tax on any gains in those funds since you bought them. To manage the tax consequences of the withdrawal, pull money out of losing funds to cancel out any withdrawals from winning funds. Then you can simply purchase more fund shares when you can.

If you withdraw from an IRA, 401k or 403b, however, you will be charged income tax on the full withdrawal amount. If you are younger than 59 and one-half years, the IRS will also charge you a 10 percent penalty. For 401k plans, the plan sponsor will withhold 20 percent of the withdrawal to pay the taxes.

Alternatives

You can borrow money from cash value life insurance, such as whole life or universal life insurance. If you have a cash value accumulated in the policy, you can borrow money against it tax-free and penalty-free. Either pay it back or carry the balance for life -- the death benefit will eventually repay the loan, plus interest. If you expect to borrow from a life insurance company, consider a policy that does not practice direct recognition -- that is, any dividends the policy earns are calculated according to the full cash value of the policy, including that portion pledged as collateral against a loan.

You can also borrow against the equity in your home. However, if you default on this loan, you may put your home at risk.

References

• Securities and Exchange Commission: Invest Wisely: An Introduction to Mutual Funds
• "USA Today": Margin loan can pay off, but risks make it, well, risky
• "SmartMoney": Should You Borrow From Your 401k or 403b?
• The Motley Fool: Borrow From Your IRA!
• Non Direct Recognition Life Insurance: Advantages of Non Direct Recognition Life Insurance Policy

Resources

• Bankrate: Should I borrow from my 401k plan?