Pitfalls of Borrowing From Your 401(k)
There's a simple rule when it comes to borrowing from your 401(k) retirement plan at work: Don't do it!
Just because 90 percent of companies allow participants to borrow from a 401(k) plan doesn't mean it's a good idea. A new study shows that 14.6 percent of participants have an outstanding loan, with the average amount of $6,216, and the typical loan duration of five years before repayment.
Now, as we enter into the second month following the holiday shopping spree, it's tempting to grab any available cash to pay down those credit card balances. And as tax season arrives, it's also tempting to borrow to pay any additional taxes due. But forget borrowing from your 401(k) plan. There are many perils and costs, which you probably haven't considered.
Here are five things to keep in mind about borrowing from your 40l(k) or similar defined contributions retirement plan.
1. Investment Cost: Many people justify borrowing because they know they will repay the loan with interest to themselves. In 2014 the average loan rate was 4.09 percent, but some plans charge a floating rate based on the prime rate. It is definitely less than the interest you will pay on a credit card, or on late payments to the IRS.
But it means that you are losing all the growth on that money during the time it is out of your account -and future growth that the money would have generated. If your borrowing takes place while the market is on an uptrend, you may never make up the forgone growth.
2. Borrowing and Repayment Rules: Each company sets its own rules, within certain DOL limits, about how much you can borrow and how you must repay. You certainly won't be able to borrow your money; loans are usually limited to either $50,000 or half of your plan assets. Typically, you have to repay money you've borrowed from your 401(k) within five years by making regular payments of principal and interest at least quarterly, often through payroll deduction.
3. Job Loss: If you lose your job, your plans to slowly repay the loan may be abruptly changed. If you fail to repay the loan within 60 days of losing your job, you will be considered to have defaulted on the loan. That will require you to pay ordinary income taxes on the amount you took out--plus a 10 percent Federal tax penalty if you are under age 59-1/2.
4. Changing Jobs: The same rules apply if you change jobs, requiring a loan repayment - even if you leave your 40l(k) plan at your former employer. When you leave employment, the loan must be repaid. This weight could make it costly to take a better job with more opportunities.
5. Penalty Cost: While studies show that 90 percent of 40l(k) plans are repaid, the remaining 10 percent who do not repay the loans within the plan's prescribed time frame or within 60 days of losing their job, account for a huge amount of taxes and penalties. The Pension Research Council estimates that loan defaults generate over $1 billion in annual tax revenues from penalties!
There are some penalty exemptions if you withdraw from a 40l(k) for large medical bills, or a qualifying disability, or even under certain withdrawal rules if you leave your job after you reach age 55. However, be aware that -- unlike in IRAs -- there are no penalty exemptions in a 40l(k) for borrowing for education expenses or a first home purchase.
Your retirement plan may look like a tempting pot of money, ready to be borrowed. There is little paperwork and no credit check required. But the consequences of borrowing could be more expensive than you realize - both now, and in the future. That's The Savage Truth.
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