Most companies that have 401(K) retirement plans allow their participants to borrow from their plan account. Unwittingly, these companies are placing their employees’ savings at risk by offering this feature, which is not a required part of any 401(K) plan.
A recent study shows that eighty-three percent of American workers covered by 401(k) plans can borrow against their accounts, and unfortunately, 20% of the participants had an outstanding loan in 2000 with an average loan balance of $6,856.
The incredibly easy process of tapping your retirement fund to buy a new house, car, boat, RV or other luxury lends itself to this unfortunate practice. You’re losing years of tax-free compounding for every dollar you borrow.
Another unforeseen consequence of borrowing from your retirement is that you may be tempted to reduce your monthly 401(k) contributions by the amount of your loan repayment to keep your paycheck stable. The only result of that strategy is that your retirement assets will stagnate while your taxes swell.
Financial services companies have encouraged employers to make loans available, saying the ability to tap retirement funds will increase worker participation in the plans. The idea is that workers are more likely to contribute if they don’t feel their money is being locked away.
People who borrow from their workplace retirement funds, meanwhile, love to think it’s a smart move, since when they repay the loan they’re essentially paying interest to themselves rather than to a credit-card company or other lender.
While this is true, 401(k) borrowers also could unwittingly be putting their retirements at risk. If they lose their jobs or get fired, the loan must be repaid, typically within weeks. If that’s not possible — and normally it’s not since people who lose their jobs don’t tend to have a lot of cash sitting around — the outstanding loan balance is taxed as normal income and penalized as a premature distribution.
So in addition to the $10,000 you borrowed to spend on that new car or whatever, you’ll be liable for thousands more dollars in taxes and penalties.
It gets worse, since you can’t put that money back. Whatever the $10,000 might have earned in future years is gone forever. Assuming an 8% return, that loan could cost you more than $140,000 in future retirement funds.
Even if you don’t lose your job, you’ll wind up paying taxes twice on the same money if you borrow from your 401(k). While contributions to the retirement accounts are pre-tax income, the money used to repay the loan is not. If you’re in the 27% federal tax bracket, for example, you have to earn $137 for every $100 you use to repay the loan. Then when you retire, you have to pay taxes again on any withdrawals.
Like home equity, retirement funds are best left alone to grow — and to be there for you in case of a true emergency.
2003 ODEC
Mike Burstein has been helping the SOHO and Small Business community grow & prosper for over 20 years by solving start up problems, creating best practices, automating their offices, getting free publicity and dramatically increasing traffic and sales.
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