When times are tough, that pool of dollars sitting in your 401(k) plan account may start to look attractive. But before you decide to take a plan loan, be sure you understand the financial impact. It's not as simple as you think.

The basics of borrowing

A 401(k) plan will usually let you borrow as much as 50% of your vested account balance, up to $50,000. (Plans aren't required to let you borrow, and may impose various restrictions, so check with your plan administrator.) You pay the loan back, with interest, from your paycheck. Most plan loans carry a favorable interest rate, usually prime plus one or two percentage points. Generally, you have up to five years to repay your loan, longer if you use the loan to purchase your principal residence.

You pay the interest to yourself, but ...

When you make payments of principal and interest on the loan, the plan deposits those payments back into your individual plan account. This means that you're not only receiving back your loan principal, you're also paying the loan interest to yourself instead of to a financial institution. But the benefits of paying interest to yourself are somewhat illusory.

Here's why. To pay interest on a plan loan, you first need to earn money and pay income tax on those earnings. With what's left over after taxes, you pay the interest on your loan. When you later withdraw those dollars from the plan (at retirement, for example), they're taxed again because plan distributions are treated as taxable income. In effect, you're paying income tax twice on the funds you use to pay interest on the loan. (Note: Special tax rules apply to Roth 401(k) contributions.)

The opportunity cost

When you take a loan from your 401(k) plan, the funds you borrow are removed from your plan account until you repay the loan. While removed from your account, the funds aren't continuing to grow tax deferred within the plan. So the economics of a plan loan depend in part on how much those borrowed funds would have earned if they were still inside the plan, compared to the amount of interest you're paying yourself. This is known as the opportunity cost of a plan loan, because you miss out on the opportunity for more tax-deferred investment earnings.

Other considerations

There are other factors to think about before borrowing from your 401(k) plan. If you take a loan, will you be able to afford to pay it back and continue to contribute to the plan at the same time? If not, borrowing may be a very bad idea in the long run, especially if you'll wind up losing your employer's matching contribution.

Also, if you terminate employment, your plan may require that your loan become immediately payable. If so, and you don't have the funds to pay it off, the outstanding balance will be treated as a taxable distribution to you, and if you're not yet 59½, a 10% early distribution penalty may also apply to your taxable balance.

Still, plan loans may make sense in certain cases (for example, to pay off high-interest credit card debt, or to purchase a home). But make sure you compare the cost of borrowing from your plan with other financing options, including loans from banks, credit unions, friends, and family. To do an adequate comparison, you should consider:

Interest rates with each alternative
Whether the interest will be tax deductible (for example, interest paid on home equity loans is usually deductible, but interest on plan loans usually isn't)
The amount of investment earnings you may miss out on by removing funds from your 401(k) plan

Recent action in the credit markets has created situations that are unusual in the relatively placid world of bonds. Whether you're hoping for a buying opportunity or are concerned about existing holdings, it can pay to understand some basics of municipal bonds.

All munis are not alike

Exemption from federal income tax isn't a muni bond's only tax advantage. If you live in the state where the muni is issued, the interest also may be free from state and local income taxes. Municipal bonds have special tax status because they are issued by state and local governments to pay for a variety of projects. Revenue bonds finance specific public works projects; their interest payments are secured by revenue from those projects. General obligation (GO) bonds are secured by the full faith and credit of the issuing body. Because of that taxing authority, GO bonds are generally perceived as less risky than revenue bonds, and usually pay a lower interest rate.

Still other muni bonds may be taxable, depending on what they're used to finance. For example, so-called private activity bonds fund projects that provide a significant benefit to private interests, such as a sports stadium. Because they lack the tax advantages of tax-exempt munis, their rates typically are more comparable to corporate bonds. They also are included when calculating any alternative minimum tax (AMT) liability, so you may want to consult a tax professional about them.

Interest paid by a muni bond fund may or may not be tax free, depending on how the fund is invested; obtain and read a fund's prospectus before investing, and weigh your objectives, risk tolerance, and time horizon.

Are munis appropriate for you?

Although the stated interest rate on a muni bond is generally lower than the rate offered by a taxable bond of similar credit and duration, a tax-free muni bond actually may provide a greater after-tax yield. The higher your tax bracket, the more attractive a tax-exempt investment becomes. For example, if your marginal tax rate is 35%, a taxable investment would need to yield 9.23% to equal a tax-exempt yield of 6%. You'll need to compare a bond investment's tax-equivalent yield to know if it's a tax-efficient choice for you.

Other factors to consider

Munis involve a variety of risks. Like other bonds, muni prices typically tend to rise when interest rates fall, and drop when rates go up. Liquidity risk--the possibility that you might not be able to sell a bond--has been a factor recently. So has credit risk--the risk (real or perceived) that a bond's issuer may not make interest or principal payments. Inflation risk also can decrease demand for bonds and in turn lower their prices, because rising consumer costs cut the purchasing power of a bond's fixed interest payments.

Every investment you own should have a specific role in your portfolio. However, even if you've established an appropriate asset allocation, it's a rare portfolio that remains static for years. Even if you don't alter your holdings, style drift may make changes for you.

Style drift occurs when a portfolio undergoes changes in its original approach. It is neither good nor bad, but monitoring changes helps ensure your portfolio reflects your intentions.

Watching for hidden shifts

Mutual funds provide a good example of how style drift can occur. Each fund has an investment objective; however, its manager may have flexibility in how that objective is pursued. For example, an actively managed stock fund may be known for investing in value stocks--those the manager feels are underpriced--while another fund might favor growth stocks with rapidly growing earnings. Depending on a manager's view of the market's future, a fund that has focused on growth stocks may shift toward value--or vice versa. Its style has drifted, even though its investment objective may have stayed the same.

The more specific a fund's name, the less latitude its manager may have. For example, a fund with a specific asset class or style in its name--let's say the hypothetical XYZ Small-Cap Fund--must invest at least 80% of its assets accordingly. Be sure to review a fund's prospectus before investing; annual and semiannual reports should show any changes.

Getting caught in a drift

Another common example of style drift is a small-cap mutual fund that has large inflows of new assets. Because there are restrictions on how much of one company's stock a single mutual fund can hold, small-cap fund managers sometimes find themselves unable to invest enough in any individual small company to affect the portfolio's performance, and invest more in mid-caps. Or they may be reluctant to sell a solid small-cap company that has grown to mid-cap size. Still other examples:

• A manager who includes a significant percentage of international securities in a portfolio that has typically focused on domestic issues
• A portfolio that departs substantially from its so-called "neutral mix" of multiple asset classes

Even though it may be within a manager's discretion to make such shifts, style drift can affect your asset allocation. If your portfolio's expected return assumes that you have a certain percentage in, say, small caps or international stocks--or that you exclude them--your allocation and overall strategy can be thrown off without your realizing it.

Drifting away from an index

Style drift also can affect the standard by which you judge a portfolio's performance. Most mutual funds are benchmarked against a relevant index to ensure that you're comparing apples with apples. If a fund's style drifts dramatically, the index may be less useful as an indicator of how that fund compares to its peers. More importantly, determining the level and type of risk to which the fund exposes you may also become more difficult.

Don't overreact

Style drift may be part of a manager's overall strategy to try to boost performance. Staying on top of whether your investments may be undergoing a makeover, and understanding the reasons behind any style drift, can help keep your portfolio on track.

The collapse of the subprime mortgage market and the jitters it's sending through the entire economy contain lessons for us all. Here are a few:

If it sounds too good to be true, it probably is. Based in part on wishful thinking ("housing values will always appreciate") and in part on misleading information ("that's a great rate"), many homebuyers became convinced they could afford mortgages they later found they really couldn't. Similarly, many investors were led to believe that mortgage-backed securities were all about huge rewards with minimal risk. So, the lesson here is: When faced with what appears to be a rosy best-case scenario, always remember to ask "But what if ...?"

Experience counts. When seeking a mortgage broker, loan originator, investment firm and/or fund manager, check out their credentials, and look for those with lengthy experience who are respected within their fields.

Read (and understand) the fine print. Many people, both homebuyers and investors, got burned in the subprime mortgage mess because they didn't know the details of the contracts they entered--and the devil is always in the details. Review all mortgage documents and/or investment prospectuses carefully before you make a commitment. If you don't understand the ramifications of what you've read, seek assistance from an unbiased qualified professional.

The best regulation is self-regulation. Federal regulations designed to protect the consumer cover many loans resold to quasi-government agencies like Freddie Mac, and loans insured by the Federal Housing Administration also carry strict guidelines. But oversight of these loans is not always as diligent as it should be. What's more, many mortgages are now originated by unregulated nonbank lenders. As a result, you shouldn't assume that governmental and/or institutional regulations will always protect you from getting into financial trouble. Only you can do that.

You work hard for your money. So why shouldn't you try to keep as much of it for yourself as you can? Here are some ways to pay less tax and keep more of your hard-earned dollars.

Tax deferrals rule

Take advantage of tax-deferred retirement plans, such as 401(k), 403(b), and 457(b) plans, offered by your employer. They all allow you to make pretax contributions of up to $15,500 in 2008 ($20,500 if you're age 50 or older), and 403(b) and 457(b) plans may also have special catch-up rules that might let you defer even more. The tax savings can be significant. For example, if your marginal tax rate is 28% and you defer $15,500, you'll save $4,340 in current taxes. Your $15,500 contribution will generate tax-deferred earnings for you until you withdraw the funds from the plan, when you may be in a lower tax bracket. And, if your employer matches your contributions, the deal is even sweeter.

Another common way to use tax deferrals to save more of what you earn is by setting up a health-care flexible spending account (FSA) at work. Your contributions reduce your taxable income, saving current taxes, and the funds you set aside can be withdrawn tax free to pay a wide variety of health-related expenses that aren't covered by your health plan. See IRS Publication 502, Medical and Dental Expenses, for a list of qualifying expenses.

And don't forget traditional IRAs. If neither you nor your spouse is covered by a retirement plan at work, and you're not yet 70½, you can make a deductible contribution of up to $5,000 to an IRA in 2008 ($6,000 if you're age 50 or older). Even if you or your spouse is covered by a plan, all or part of your contribution may be deductible, depending on your income.

But tax free is even better

If you're an income-oriented investor, consider investing in municipal bonds. The income generated is free from federal income taxes and, in some cases, state income taxes as well. (Be sure to compare yields between taxable and tax-free securities, and keep in mind that certain municipal bond income may be subject to the alternative minimum tax.)

Another way you can generate tax-free income is by contributing to a Roth IRA, Roth 401(k), or Roth 403(b) plan. Unlike pretax deferrals, Roth contributions don't reduce your income, so there's no current tax savings. Because you've already paid tax on your contributions, they won't be taxed again when you withdraw them from the plan. But what really sets Roth contributions apart, and makes them so appealing, is that all earnings are also tax free if you satisfy a five-year holding period and certain other requirements are met.

If you have children, don't pass up the tax incentives offered by Section 529 plans and Coverdell education savings accounts (ESAs). Again, your contributions to these plans aren't tax deductible, but your savings grow tax deferred and withdrawals are tax free at the federal level (and typically at the state level too) when used to pay qualifying educational expenses. You can contribute up to $2,000 to a child's Coverdell ESA in 2008, and most 529 plans let you contribute more than $300,000 over the life of the plan.

Think long-term--for capital gains

Long-term capital gains tax rates are currently very attractive--a maximum of 15% through 2010. Short-term capital gains, on the other hand, are generally taxed at ordinary income tax rates--currently as high as 35%. To qualify for long-term capital gains treatment, make sure you hold your securities and other capital assets for more than one year before selling them.

For lower-tax bracket individuals, the long-term capital gains tax rate temporarily drops to 0% in 2008, 2009, and 2010 (in 2011, this rate reverts to 10%). This may be a signal for some investors to sell. Before you advise your clients, be sure you understand who qualifies and who doesn't.

The 0% tax rate applies only to individuals (not corporations) in the 10% and 15% tax brackets who have net capital gain and/or qualified dividend income. The income limit for these brackets in 2008 is $65,100 for joint filers, $43,650 for heads of household, and $32,550 for single filers and married persons filing separately.

Net capital gain generally is the excess of net long-term capital gains over net short-term capital losses, subject to certain netting rules. The 0% tax rate doesn't apply to collectibles gains or to gains on sales of certain small business stock, which are taxed at a maximum rate of 28%. It also does not apply to unrecaptured Section 1250 gains, which are taxed at a maximum rate of 25%.

Qualified dividends are dividends received during the tax year from domestic corporations and qualified foreign corporations. A qualified foreign corporation is an entity incorporated within a U.S. possession or one that is eligible for the benefits of a comprehensive income tax treaty with the U.S. that includes an exchange of information program (the current income tax treaty with Barbados is specified as not being sufficient). Dividends paid by a foreign corporation that is not a qualified foreign corporation are eligible for the new rates if the stock of the corporation on which the dividends are issued is traded on an established U.S. equities market.

One group of taxpayers who won't benefit from the 0% rate is children affected by the newly expanded kiddie tax rules. For 2008, dependent children under 19 and certain full-time students under 24 will be affected by the special rules that will apply their parent's higher tax rate to their investment income in excess of $1,800.

The U.S. dollar has struggled over the last few years. The Canadian dollar recently reached parity with the greenback for the first time in three decades. In October 2000, the euro was worth 82 cents. Last year it hit a record $1.45 and kept going, while the British pound sterling was at a 25-year high. (All statistics are from the Federal Reserve system.) According to the Federal Reserve Board of Governors, as of last August the dollar had dropped 26% (adjusted for inflation) against the major industrialized nations' currencies, and 7% against key emerging-market currencies, since early 2002.

If you have no plans to travel abroad, don't eat imported out-of-season fruit, and buy only domestic cars, a weaker dollar may not worry you. However, a falling dollar can lead to rising inflation. Not only can it affect the price of commodities such as oil, but with the higher cost of overseas products, domestic manufacturers may feel more comfortable raising prices. And inflation can lead to higher interest rates, which could affect everything from credit cards to mortgage rates.

A diluted dollar also can affect your portfolio. If you've held international investments in the last few years, you may have caught a tailwind. Past performance is no guarantee of future results, of course, and there are special risks to global investments, including not only currency risks but also political risks and different accounting standards. Risk factors vary considerably by country and region, and as with any investment, you can lose some or all of the funds you invest.

However, returns produced in part by the dollar's decline are one reason investing globally has become popular. According to the Investment Company Institute, more than 90% of the $160 billion of net new money added to stock mutual funds in 2006 went into funds investing in foreign companies.

Looking over the hedge

A mutual fund that invests overseas may or may not try to hedge against currency fluctuations. Some are managed to try to minimize the impact of exchange rates; others deliberately do not hedge their currency exposure. Your preferred approach will depend on your view of the dollar's future and how much currency exposure you want in your portfolio. A weaker dollar may boost an unhedged fund's performance because the fund holds securities denominated in other currencies. However, an unhedged fund would suffer more from any dollar recovery. Obtain and read a fund's prospectus carefully before investing.

Domestic can also be global

A weak dollar makes U.S. companies' products cheaper abroad, which has benefited many large multinational corporations that are headquartered here but have substantial overseas sales. According to Standard & Poor's, roughly 44% of the 2006 revenues of companies in the S&P 500 Stock Index came from international sources; in 2001, that figure was 32%. Even companies without overseas operations may benefit. For example, with higher prices for overseas goods, some distributors and retailers have begun to find less expensive U.S. suppliers. Also, a weak dollar in the past has made some U.S. companies targets for foreign acquisition.

What goes down can come up

The dollar goes through cycles, of course. A stronger economy, higher U.S. interest rates or lower rates abroad, foreign currency crises, market turbulence, or lower federal deficits could help boost the dollar's value. When determining your overall asset allocation, consider both your currency exposure and your level of international investments.