Financial Literacy - Smart borrowing
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Need cash? There's your 401(k) ...

Breaking open the 401(k) plan piggy bank can be tempting if you're in a financial jam. And it appears that more Americans are giving in -- jeopardizing their futures to meet current financial needs.

Several retirement plan providers, including Fidelity and T. Rowe Price, have reported increases in loans and withdrawals for 2007. Anecdotally, Bankrate has received an increasing number of requests for Money Makeovers from readers who report they already have seized funds from their 401(k) plans due to financial stress, or they are considering doing so in the near future.

"Now, as the housing crisis grips the country, more and more individuals are tapping their 401(k)s," say Christian E. Weller and Jeffrey Wenger of the Center for American Progress in their report, "Robbing Tomorrow to Pay for Today: Economically Squeezed Families are Turning to Their 401(k)s to Make Ends Meet."

The authors compiled several years' worth of data from the Federal Reserve Board's Survey of Consumer Finances and concluded that loans against defined contribution plans have increased from $6 billion in 1989 to $31 billion in 2004, the last year for which data are available. It's surely a bigger number today.

To borrow or not to borrow
  1. Hardship withdrawals
  2. Loan logistics
  3. Pros and cons
  4. 401(k) debit cards
  5. Weighing the options

Hardship withdrawals

Not all employer plans allow you to tap your funds, but most do. At the end of 2006, 85 percent of 401(k) plan participants were in plans offering loans, according to an August 2007 Issue Brief by the Employee Benefit Research Institute. If your plan permits, you can also opt to take a hardship withdrawal.

Generally, hardship withdrawals can only benefit you, your spouse or your children, and they can only be taken under specific circumstances:

  • For unreimbursed medical expenses.
  • To buy or repair a primary residence.
  • To pay for higher education costs.
  • To prevent eviction from your home or foreclosure on your mortgage.
  • To pay for funeral expenses.

Certain specific guidelines must also be met, including the suspension of contributions to your 401(k) plan for six months following the withdrawal. You'll have to pay income tax on the distribution, plus a 10 percent early withdrawal penalty if you're under age 59½. Together, that's could add up to 40 percent of your take. Ouch!

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"The biggest detriment with hardship withdrawals, besides the penalty, is that you can never put the money back into the account. Once it's out, it's out," says Sri Reddy, head of retirement income strategies at ING.

Loan logistics

The alternative, taking a loan from your 401(k), helps you avoid completely hijacking your retirement because at least you pay yourself back.

Again, depending on the provisions of your plan, loan availability may be unrestricted or it may be limited to the same types of circumstances permitted for hardship withdrawals. In the latter case, plan administrators generally require documentation to prove the need exists.

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