Among pirates of old, the term “booty” referred to any prize or gain realized as a result of their nefarious efforts. While most people fund their 401(k) or similar retirement plan in a more civilized fashion, attempting to access these funds before normal retirement age can scuttle one’s financial future.
When personal finances are stretched thin or there is a desire to make a large purchase, such as a new home, it can be very tempting to plunder the retirement account for easy access to the riches within. Unless faced with extremely serious financial threats – such as bankruptcy – it is better to think long and hard before raiding those retirement dollars. The costs and long-term consequences may be worse than imagined.
401(k) Loans Are Easy
Most employer retirement plans will not allow workers to take in-service withdrawals from their 401(k) accounts. The plan may, however, allow participants to “borrow” a portion of their own funds and repay the balance over time through payroll deduction. When taken as a loan, these funds are not subject to IRS taxes or penalties for early withdrawal, as long as strict IRS rules are followed. Unlike a consumer loan, this one doesn’t require a credit check, either. Unfortunately, the advantages of taking a loan from a 401(k) end there.
Taxes and Penalties on 401(k) Loans
This convenient access still comes at a significant cost to the account owner. Generally, 401(k) loans must be repaid within five years, along with interest that accrues on the loan. A hidden cost for this type of loan is the forfeited tax-deferred growth that otherwise would accumulate had the pre-tax contributions remained untouched in the account. Furthermore, the loan is repaid with interest using after-tax dollars- dollars that will again be taxed when the owner takes distributions during retirement. Effectively, this ill-fated strategy forces the account owner to pay interest to borrow his or her own money, while replacing the borrowed funds with an amount that is likely to be smaller than it would otherwise have been if it remained untouched within the retirement account.
Borrowing Against A Retirement Plan May Be Costly
If those consequences don’t appear to be so awful, they could become much worse. If a 401(k) borrower changes jobs, for whatever reason, the IRS will insist upon repayment of the entire outstanding 401(k) loan balance within just 60 calendar days. There is no special provision in the tax code for layoffs, although IRS Publication 575 does mention a few other possible exceptions to the rules for taxes and penalties on early distributions from qualified plans. This compressed repayment schedule can become quite a challenge when the original strategy was to pay back the loan in 60 months. If the borrower misses the 60-day repayment deadline, the IRS will consider the outstanding loan amount to be a premature withdrawal, triggering both current income taxes and a 10% penalty on the unpaid amount of the loan. Most people would not agree to a five year loan charging a 30% interest rate, yet for someone in a 20% tax bracket, defaulting on repayment of a 401(k) loan could be tantamount to making a deal with a loan shark.
Alternatives to Borrowing
Most people can find alternative ways to fund their needs and desires without putting hard-earned retirement funds at additional risk. Often, simply delaying significant purchases and controlling spending can make all the difference. With the uncertainties of Social Security retirement, increased life spans, and rising medical costs, it is important to do everything possible to preserve and protect the funds needed to live comfortably in those golden years.
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