Borrowing From A 401(k): Avoid It If You Can

By Gini Scott

2001-06-18

Thinking of borrowing from a 401(k)? The resounding advice of financial advisors is: "Don't do it!"

That's because making an early withdrawal results not only in loss of interest but also in tax penalties. Ideally, then, it's better for an employee to borrow funds from another source if possible, such as a home equity line, which has a lower rate than nonsecured loans and deductible interest. Another good option for those with a brokerage account is taking a margin loan, since the stocks in the account may continue to earn a return while the loan is outstanding and there is no tax consequence for not paying the loan in time.

However, if an employee needs the funds in an emergency and has no other alternatives, it is better to borrow than to pull the money out before the magic retirement age of 59 1/2. This way the employee avoids the 10 percent penalty on early distributions if the money is paid back within five years. Then, too, under certain circumstances, an employee can avoid penalties or reduce them, depending on the particular plan.

The trend now is for employees to increasingly borrow from these plans. In 1998, for example, 9 percent of the participants in 401(k) plans took loans against these plans, borrowing about $18.2 billion, with an average of $7600 per loan, according to Ginger Applegarth, a financial advisor for Money Central on MSN. Another study, the 1998 Survey of Consumer Finances, shows that borrowing from these plans more than doubled between 1992 and 1998.

Today most plans do allow loans, and plan holders are allowed to borrow up to 50 percent of their vested account balance with a $50,000 cap. The usual payback period is up to five years, although the payback is longer if the loan is for a first home. Typically, the interest rates are one to two percentage points over the prime rate.

While some plans permit employees to borrow for any reason, most require that the money be only used for a financial hardship, based on IRS guidelines. Presumably, as these guidelines state, the withdrawal must be due to "an immediate and heavy financial need" such as: payment of unreimbursed medical expenses, purchase of a primary residence, payment of post-secondary educational expenses, and payments to prevent an eviction or foreclosure on a primary residence. Employees are also supposed to show their employer proof of how they intend to use the money and that the money requested isn't more than enough to satisfy their need.

For employees who face difficult conditions, the basic advantages of borrowing from a 401 (k) are that:

• Once the account vests, there is no credit check, so the employee can get the needed loan and plan accordingly - - and the loan is convenient to obtain. Generally, the employee only needs to fill out a short loan form or make a phone call to get it.
• The employee gets a low interest rate and the interest is tax-sheltered, since the money isn't taxed until the money is taken out of the plan until retirement.

However, there are many disadvantages, which is why advisors recommend against them if possible. Among the disadvantages,

• The employee loses interest, which can be substantial due to the compounding effect.
• The employee loses tax-shelter benefits, since when s/he repays the loan, these payment are made with after-tax dollars.
• If the employee is unable to repay the loan, it is treated as a premature distribution, so the employee now owes both federal and state income taxes, plus a 10 percent penalty if s/he is under 59 1/2, though there are certain exceptions. (Among them are if the employee becomes disabled as the IRS defines this or if the employee leaves the company during or after the year in which he or she turns 55).
• If the employee leaves the company for whatever reason, most plans require that the employee pay the outstanding balancewithin 30 to 90 days. If not, the loan is considered in default and the outstanding balance is treated as a taxable withdrawal; plus there may be a 10 percent early withdrawal penalty if the employee is under 59 _. If the employee has to cash in assets to make that payment, there can be more taxes and a penalty on that amount, too.

In short, employees should only borrow from these plans if they have no better alternative - - and if they do borrow, they should pay the funds back not within five years, but as soon as possible.

By Gini Graham Scott, Ph.D., J.D. Gini is the Director of Changemakers and the author of three books on creativity and innovation: Mind Power: Picture Your Way to Success in Business and The Empowered Mind: How to Harness the Creative Force Within You (both from Prentice-Hall) and The Innovative Edge (out in September 2001 from Ronin Publishing). Gini’s Web site is at www.giniscott.com.