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!

“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.

The procedure is simple. You fill out a short form, choose which investments to sell to generate the cash and then the money is transferred to your bank account.

Payments are usually made by payroll deduction and the interest rate charged is generally 1 percent higher than the prime rate. Many plans also charge a loan origination fee.

Pros and cons

Though a seemingly sweet deal, some details within 401(k) loans are not so alluring.

Pros and cons
Good deal Bad deal
Pay yourself interest.
Easy loan application.
The loan is only temporary.
No credit repercussions. If you lose your job and default on the loan, it will not show up on your credit report.
Double taxation.
Unlike other loans, the interest payments are not deductible.
Funds lose out on potential market growth and compounding earnings.
Taxes and penalties will be due since the loan will be treated as a distribution.

1. Pay yourself interest. Paying interest to yourself instead of a finance or credit card company would seem to be a big positive. After all, you’re the one profiting from the interest.

But, says ING’s Reddy, you get into a double taxation situation. While it’s likely you are borrowing money that was contributed on a pretax basis, you must pay yourself back with after-tax money.

“Let’s say you borrow $10,000 and the interest rate is 6 percent,” he says. “The $600 you’re paying back to yourself, you’ve already paid taxes on it. So you had to earn $1,000 to make that $600. When you take it out at retirement, it’s probably going to get taxed again. So you’re going to end up with around $350 or $400 out of $600,” he says.

2. Easy loan application. Some borrowers may prefer to turn to their 401(k) rather than going for a home equity loan, especially since fewer lenders are offering them.

A big plus: The loan application to borrow from a 401(k) is easy and straightforward, plus there is no credit check required.

“You just fill out a form and that’s it,” says Jay Fik, a Certified Financial Planner and wealth transfer specialist at Consulting Services Group in Tennessee. “You are limited to 50 percent of your vested account balance with a maximum of $50,000, and that is based on IRS guidelines.”

A downside to using 401(k) funds: The interest you pay to yourself is not tax deductible. Interest paid on mortgages, home equity or student loans generally does qualify as a tax deduction.

3. Temporary loan. Most loans are repaid over five years, though a large loan used to buy a primary residence generally can be repaid over 20 years.

Borrowers who repay their loans run the risk of suspending their regular retirement contributions. So not only is the borrowed money not invested in the market; borrowers may not be adding any more contributions as long as they are repaying the loan.

“It could be a slippery slope because the repayments do come out of your paycheck, which lowers your take-home pay,” says Fik.

Adding regular contributions to the loan payment would further reduce it.

If the borrower has extra money to pay back a loan and make new contributions, he or she probably would not have taken a loan in the first place, he says.

4. No credit repercussions. Borrowing from yourself might seem particularly advantageous for consumers with poor credit, but if your job is in jeopardy or you believe you may change jobs in the near future, taking a loan can be costly.

If you lose your job or move on to new employment, the outstanding loan usually becomes due within 60 days. If you don’t pay it, after that time it becomes a distribution and will be subject to income tax and the 10 percent early withdrawal penalty.

401(k) debit cards

Legislators are concerned about the ease with which Americans can put their retirements at risk by taking out loans. Add to this a relatively new feature for some 401(k) plans: the 401(k) debit card.

A bill recently introduced in the Senate would limit the number of loans an individual can take from their 401(k) accounts to three and ban the use of 401(k) debit cards, currently offered by only one company. The Securities and Exchange Commission and the Financial Industry Regulatory Authority have issued warnings to investors about their use.

Lawmakers should restrict access to 401(k) loans, says Christian E. Weller, Ph.D., senior fellow at the Center for American Progress, an associate professor of public policy at the University of Massachusetts Boston and co-author of the earlier mentioned study on 401(k) loans.

“I know some economists who go even as far as saying you should completely ban loan access,” he says.

Such extreme measures may not be necessary. Weller’s own research shows that Americans generally don’t enter into the decision lightly, tapping into their 401(k)s only when under financial duress.

“Among the group of people who have access to these loans, we find that it is people who are already financially strapped who need to pay for economic necessities. They need to cover a spell of unemployment of a family member or they need to pay for medical care or they need to buy a house. They’re not going out on shopping sprees,” he says.

“Among the group of people who have access to these loans, we find that it is people who are already financially strapped who need to pay for economic necessities. They need to cover a spell of unemployment of a family member or they need to pay for medical care or they need to buy a house. They’re not going out on shopping sprees,” he says.

Pending a decision on the debit cards by Congress, these instruments are actually being adopted by companies in increasing numbers.

“I haven’t seen one personally, but I understand that they are growing in popularity, especially at service-related businesses with high turnover,” says Fik.

“Its been pitched as a thing for younger employees to make sure they are saving — like they are not going to defer their income to a savings account unless they can have access to it.”

Weller testified before Congress in opposition to the debit cards and points out two main problems with them. First, they make it too easy for workers to access their retirement accounts. Second, they are a bad deal for consumers.

Though the fees involved are similar to a standard 401(k) loan, the company offering the cards — Reserve Solutions, an affiliate of The Reserve — also charges additional interest on top of the nominal rate.

“In Congress, when we testified together, Mr. Bruce Bent, the head of The Reserve, said, ‘Well, you would pay 5.5 percent interest to yourself and you would pay somewhere between 2.9 (percent) and 3.25 percent’ — so roughly 3 percent to him,” says Weller.

That brings the total interest charged to the borrower to 8.5 percent.

“This is a substantial burden. If people really take out a 401(k) loan because they have to, then we shouldn’t burden them with extra costs,” he says.

Weighing the options

“There are a lot of people out there that would say 401(k) loans are a horrible thing and they would start ranting and raving about them,” Fik says. “But people are strapped right now.”

ING’s Reddy recommends you ask yourself three questions before tapping your 401(k) plan:

3 quick questions
  • Why do you need a loan? If it’s to buy a new car, that’s not a good reason.
  • Do you need to spend the money now, or can you wait until you’ve saved more cash? If you do need to spend it now, the third question is:
  • Is there an alternative? For instance, if you need medical services, will the vendor work with you and work out a payment plan? If not, try to find another vendor.

Reddy also recommends exhausting all other sources of savings before taking a loan from a retirement account.

“I’ve actually encountered people who have taken money from their 401(k) plan, but are still funding their child’s college fund,” he says.

In emergency situations, the ability to take a loan from your 401(k) can be a good thing.

But it should only be used in situations where the consequences of not taking the loan outweigh the steep price that borrowers pay for taking money out of their retirement account.

What steep price? The authors of the 401(k) loan study say that even a small loan of $5,000 in today’s dollars reduces future retirement savings by between 13 percent and 22 percent.

And that is a price that few can afford.

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