Home & Family Finance

Tough Times Series: 401(k) Loans Poach Nest Eggs

Monica Steinisch

Struggling families are increasingly borrowing retirement plan funds to bridge the gap between stagnant wages and soaring prices, according to a July 2008 report titled "Robbing Tomorrow to Pay for Today: Economically Squeezed Families are Turning to Their 401(k)s to Make Ends Meet." As authors Christian E. Weller and Jeffrey Wenger, both of the Center for American Progress, point out, the popularity of these loans has increased in part because lenders have tightened access to home equity loans and other types of credit. The loans also are popular because of their seemingly favorable terms, such as interest paid back to oneself.

But, while the loans do offer low interest rates and a quick solution to immediate money troubles, they may not be the great deal they appear to be. Stringent repayment requirements, significant tax consequences, and loss of investment earnings make borrowing from a 401(k) account an option that requires careful consideration.

How a 401(k) loan works

Whether you can borrow from your 401(k) or similar defined contribution retirement plan is up to the plan sponsor—in other words, your employer. Most big companies allow borrowing; some small companies do, too. Industry statistics indicate that about 85% of plan participants are allowed to borrow from their 401(k) accounts.

Federal guidelines allow you to borrow a maximum of $50,000 or 50% of your vested 401(k) balance, whichever is less, though employers have the option to set lower caps. Many plans will set a minimum loan amount, as well.

Since it's your money, there's no credit check.

You must repay the loan within five years through payroll deductions. (A longer repayment period is allowed if you use the money to purchase a home.) If you leave the company while you still have an outstanding loan balance, the loan becomes due immediately. If you can't repay it within 60 days to 90 days, it's considered a distribution and you will have to pay income taxes on the remaining balance, and a 10% early distribution penalty if you are younger than 59½.

A credit union loan officer also can help you evaluate your alternatives.

The interest rate on loans is set by the plan. It is typically prime plus one percentage point to two percentage points—lower than the rate charged on many other loans. And, the interest you pay goes back into your account.

If your retirement money is in mutual funds or other investments, you may have to choose which, if any, investments to sell to generate cash. The money is then given to you in a check or transferred to the account you specify.

For information and guidelines specific to your 401(k), see the Summary Plan Description available from your employer or plan administrator.

The costs of borrowing from your retirement plan

Many borrowers see a 401(k) loan as an inexpensive solution to money problems.

"[Retirement plan] loans are often misrepresented as a tax-free way to get your hands on the money, and I question that view," says Ted Benna, the tax consultant considered the father of the 401(k) plan and co-author of "401(k)s for Dummies."

In reality, workers who borrow from their 401(k) accounts ultimately pay out about as much in taxes as those who take a hardship withdrawal, says Benna. That's because borrowers repay their loans through after-tax payroll deductions. Someone in the 28% tax bracket, then, would have to earn more than $700 to clear enough, after federal, state, local, and Social Security taxes, to make a $500 loan payment. And the interest borrowers pay isn't tax-deductible, the way it is on a home equity loan or mortgage.

Even a small loan of $5,000 reduces your future nest egg by between 13% and 22%.

Taxation isn't the only issue Benna and others have with retirement plan loans. They also cite lost growth potential while the money is not invested. And even though borrowers do pay themselves interest, the rate typically is too low to match what the money could have earned elsewhere over five years.

Perhaps the biggest blow to borrowers' future financial security, say experts, is the reduction or suspension of retirement plan contributions while the loan is being repaid. That, says Benna, is particularly important if the employer offers matching dollars on employee contributions.

For example, let's say you normally would contribute $400 per month, or $4,800 per year, to your 401(k), and your employer contributes 50 cents for every dollar. Suspending your contributions would cause you to miss out on $2,400 in employer contributions in a single year—or $12,000 over the five-year loan repayment period. And that significant loss does not even include foregone investment earnings on the money over that period.

Weller and Wenger, the authors of the 401(k) loan study, say that even a small loan of $5,000 reduces a borrower's future nest egg by between 13% and 22%.

If you want to see what a 401(k) loan would cost you, try out Standard & Poor's online "Borrowing From a 401(k) Calculator".

Other options when money is tight

Todd Mark, a spokesperson for Consumer Credit Counseling Service of Dallas, acknowledges that a 401(k) loan might be a reasonable option if someone is facing foreclosure or bankruptcy. But, he says, it's not "a decision you take lightly."

Weigh the long-term costs of a 401(k) loan against the benefits.

If tapping an emergency fund isn't an option at this point, either because you don't have one or because it's been depleted, Mark says to look for other alternatives.

"For instance," says Mark, "If you need medical services, will the vendor work with you, and work out a payment plan? If not, try to find another vendor."

After cutting expenses and increasing income as much as possible, Mark encourages consumers in a financial bind to look to family members, friends, local nonprofits, and other possible sources of a short-term loan. And, he says, you should consider tapping college savings before retirement accounts, if you have them. (The ability to do so without penalty and tax consequences will depend on the type of account those savings are in.) You can borrow to finance higher education; you can't borrow to fund your retirement.

Benna agrees that the conclusion to borrow against your retirement should come only after serious deliberation.

"Even in cases [of possible foreclosure], I would encourage someone to make an informed, intellectual decision rather than an emotional one," he says.

That means weighing the projected long-term costs of the loan against the benefits. If, for example, a 401(k) loan will just delay an inevitable foreclosure or bankruptcy, then borrowing from your account could put you in the worst possible position: losing your home or filing bankruptcy now and having thousands of dollars less to live on in retirement.

In most cases, preventing eviction or foreclosure qualifies you to take a hardship withdrawal from your 401(k). With a withdrawal, you must pay income tax on the distribution, plus a 10% early withdrawal penalty if you're younger than age 59½. You never can put the withdrawn amount back into the account. And, you may be required to suspend contributions to your 401(k) plan for six months following the withdrawal.

Your nest egg was never intended to be a rainy-day fund.

Of course, the best way to avoid having to make the tough choice between present and future financial needs is to practice prevention.

The 401(k) study researchers determined that families take retirement plan loans "because they are either uninsured or underinsured for the risks they face." If you are not already eyeing your 401(k), conduct a personal insurance evaluation to see where you might need more protection. The types of coverage you need depend on a variety of individual circumstances. But most people who rely on employment earnings to pay their bills should be prepared for a loss of income due to injury or illness. (Read "Short-Term Disability Insurance a Safety Net for Workers" to learn more about this coverage.)

And don't overlook the importance of self-insuring through an adequate emergency fund.

"Emergency savings is key," says Mark. How much is adequate for you will depend on factors such as your income, expenses, other financial resources, and employability. A credit counselor, credit union representative, or other financial professional can help you determine how much of a financial cushion you need.

A credit union loan officer also can help you evaluate your alternatives. You may be able to restructure some existing debt to better manage your obligations.

As you consider the resources that would be at your disposal if money got tight, cross "401(k) account" off your list. Your nest egg was never intended to be a rainy-day fund.

Neither CUNA nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions.

401(k) debit cards

A 401(k) debit card enables workers to tap their preapproved 401(k) loans at any ATM or merchant that accepts Visa-branded credit cards. The card is far from mainstream—only a small handful of employers offer them, and there are efforts to ban them altogether—but it is available to some employees. And it does offer a few real benefits for borrowers, such as the option to pay more than the minimum amount due each month—something you typically can't do with a traditional 401(k) loan.

But, there are at least a couple of major drawbacks to the card says Christian E. Weller, senior fellow at the Center for American Progress, Washington, D.C., and co-author of the report, "Robbing Tomorrow to Pay for Today: Economically Squeezed Families Are Turning to Their 401(k)s to Make Ends Meet."

First, Weller says, they make it too easy for workers to access their retirement accounts. Second, they are a bad deal for consumers. That's because a traditional 401(k) charges an interest rate that typically is prime plus one or two points—all of which goes back into the borrower's account. A loan linked to a debit card typically has charged around three percentage points more than the prime rate. And the additional interest—above prime—goes to the company administering the debit card program, not back to the borrower. There are transaction and maintenance fees on top of that, all of which increase the bite out of your nest egg.