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With today’s shrinking home values, rising adjustable mortgage rates, and tighter loan standards, many people are turning to their 401(k) plans as sources of needed cash. But early withdrawals can exact a
heavy price, and even borrowing from a 401(k) can have adverse consequences.

What could happen to your nest egg

Due to the tax effect, withdrawing funds from a qualified retirement plan is not like taking cash out of your bank account. A 401(k) withdrawal is taxed as ordinary income, and if you’re under age 59½, a 10% penalty usually will be added to the tax. Borrowing from a 401(k) generally is preferable to simply withdrawing the funds, because no tax applies to the loan proceeds.

However, many plans either restrict their participants’ borrowing or don’t allow borrowing at all. Where loans are permitted, they’re individually limited to the lesser of $50,000 or one-half of the borrower’s plan assets. Most 401(k) loans require interest at one or two points above the prime rate, and the loans must be fully repaid within five years, unless the proceeds are applied to a personal residence. The borrower must sign a legally enforceable loan agreement and adhere to the agreement’s terms.

If you leave your job with a 401(k) loan outstanding, you’ll generally have 30 to 90 days to either fully repay the loan or face being taxed (and penalized, if you’re under age 59½) on the outstanding balance. When you repay the loan, you’ll be paying with after-tax dollars, and you’ll be taxed again on those dollars when
you withdraw them upon retirement. And unlike ordinary mortgage interest, the interest paid on a 401(k) loan used to buy or improve a home is not deductible.

Borrowing from a 401(k) is an especially bad idea for funding an ongoing cash need. For example, using the proceeds to offset a hike in your adjustable mortgage payments would only compound the problem. You’d be burdened with an additional loan, the proceeds eventually would run out, and the mortgage payments almost certainly would not go back down.

Finally, borrowing from your 401(k) tends to defeat the purpose of participating in the plan in the first place — to accumulate funds for a comfortable retirement. Removing money from a fund slows its growth, particularly since most people must cut back on current contributions in order to make repayments.

Filed under: Finance