Times are tough and many are finding it difficult to make ends meet. With the recent
credit crunch, rising oil prices and real estate meltdown, many are finding it difficult to
pay all their bills, and wonder if their 401(K) might provide a solution.
It is possible to take hardship distributions from 401(K) plans while still an employee but
only under certain conditions: (1) to pay for medical expenses, (2) to purchase a
principal residence, (3) to pay tuition for post-secondary education, (4) to prevent
eviction or halt mortgage foreclosure proceedings, (5) to pay for funeral expenses for
the employee and close relatives and, a couple of other special situations. Even if you
qualify for one of the above special reasons, you’d have to pay taxes and a 10 percent
penalty if you are not 59 and ½ or older.
Since hardship distributions are quite restrictive and expensive, borrowing from your 401
(K) may seem like good choice. Many 401(K) plans allow employees to borrow from
their plans.
You can typically borrow up to fifty percent of your vested account balance or $ 50,000
whichever is smaller. Then, you usually has five years to repay the loan at an interest
rate about one or two percentage points above the prime rate (prime rate is currently
five percent). There is no credit check required and the interest is credited to your
account. So what’s the downside?
There are several reasons why borrowing from your 401(K) is a bad idea. First of all, it
will make it difficult to reach your long-term retirement goals. The money you borrow will
not be able to grow tax-free until it is paid back. And the repayments must be made with
after-tax money. Borrowing from your 401(K), therefore, slows down your retirement
saving. For example, assume you contribute $ 2,000 less to your 401(K) this year due
to a 401(K) loan. If you could earn an average 8 percent on that money, your $ 2,000
would have grown into $20,000 in 30 years. Some would argue that the interest on the
loan, at 6 percent to 7 percent currently, is better than what the stock market is
currently returning. However, you are paying that interest, essentially moving the money
from one pocket to another. Paying the interest, in no way, increases your net worth.
The second problem with 401(K) loans is that if you terminate your employment for any
reason the loan must be paid back, typically, within 60 days. If not, it will be considered
a distribution with Federal and State taxes due. And, if you are under age 59 and ½,
you will be hit with a 10 percent early distribution penalty. Since in most cases the loan
was taken because other sources of cash were unavailable, having to pay it off within 60
days could present a real problem.
401(K) loans can easily become a vicious circle, brought on by poor financial habits
such as not creating an emergency fund or running up too much credit card debt.
Although home equity loans can also become a bad habit, you would be better off with a
home equity loan than a 401(K) loan, since the interest would be tax deductible and
there is no risk of being forced into a 60 day pay-off requirement.
There are some situations where a 401(K) loan is the only option. If you are forced to
borrow this way, do everything you can to pay it off as soon as possible. Better yet,
make sure you’ve got your finances in order so that you are never faced with a 401(K)
loan as your last resort.
David C. Patterson, CFP® and Erin Preston, CFP® are the owners of Patterson
Advisors, LLC, a fee-for-service-only financial advisory firm. Patterson Advisors, LLC is
a Registered Investment Advisor, registered with the State of Michigan, helping clients in
Waterford, Clarkston and Royal Oak, Michigan as well as other Oakland County,
Michigan communities . Visit www.pattersonadvisorsllc.com for more information or call
248-674-2108.
Published in the Oakland Insider, September, 2008, retitled: "Tapping Into a 40(K) Loan
Should be a Last resort"
401(K) Loan Should be a Last Resort
By David Patterson and Erin Preston (formerly Patterson)