New York – For many people, the money accumulated in a 401(k) retirement savings account represents most – if not all – of their total savings. So it’s a tempting target when they need cash, whether to get through a short-term emergency or to help with a long-term goal like financing a child’s college costs.
But experts say the negatives outweigh the positives when it comes to borrowing from 401(k)s and other company-sponsored retirement accounts.
“I would never say don’t do it ever,” said John Nersesian, a financial planner with Nuveen Investments in Chicago. “It can be very helpful if done selectively, but destructive if done irresponsibly.”
The main reason people tap their retirement accounts is that they’re borrowing their own money and paying it back with interest that’s usually set at a favorable rate, often close to the prime rate banks reserve for their best customers.
The thinking goes, “It’s my money anyway, so I might as well borrow it and pay myself back rather than a bank.” And it’s generally easy to get at retirement account money, often requiring only a phone call to the plan administrator or filling out a simple form.
According to the latest figures from Fidelity Investments, the nation’s largest provider of retirement plans, some 20 percent of active retirement savers had loans outstanding in 2005. The average loan was $8,000, and it represented about 15 percent of the worker’s total account balance.
Nersesian, who is managing director of Nuveen Investments’ wealth management services, said not all plans allow loans.
Those that do must abide by Internal Revenue Service rules limiting loans to 50 percent of the vested account balance or $50,000, whichever is less.
And while borrowing from a 401(k) is better than cashing it out, it is not without problems. The biggest occurs if the worker leaves his or her job before the loan is paid off, he said.
“If you can’t pay it in full, it’s treated as a distribution from the plan,” Nersesian said. “Then it’s subject to income tax as well as a penalty – 10 percent if the worker is under 59 1/2.”
Equally bad, Nersesian said, “you now have less money in your sheltered account … to benefit from tax-deferred compounding.” In other words, there will be less money available to fund retirement.
Catherine Williams, a credit expert with Money Management International, a Houston-based financial counseling and education agency, said the cons of borrowing from a retirement account far outweigh the pros.
“In many cases, your human resources department – and often your immediate manger – becomes aware of the loan, meaning that the people you work with are privy to your personal financial problems,” she said.
Some retirement plans don’t allow participants to make new contributions until their loans are paid off; some even withhold the “match” that employers give to workers who save.
In addition, if the money is borrowed for day-to-day expenses, such as paying down credit card bills, “then it’s not there for a true emergency, such as a health emergency,” Williams said. “The last thing you want is trading a secure future for discretionary spending.”
