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Borrowing from retirement plans full of pitfalls

It's Your Money

Posted: April 11, 2008 4:54 p.m.
Updated: June 12, 2008 5:02 a.m.
 
With the weakening of home prices and lenders tightening credit, an increasing number of Americans are borrowing money from their retirement plans. A Duke University Magazine survey found in December that nearly 20 percent of companies have seen increased hardship withdrawals and loans from 401(k) accounts, often to cover mortgage payments or to avoid personal bankruptcy.

On the surface, these withdrawals may offer some advantages for those who have found it difficult to obtain money from home equity loans.

But in the long term, the disadvantages clearly outweigh the advantages, so say financial advisers. The main difficulty with borrowing from a plan is that it is the major retirement savings asset of most Americans. Taking withdrawals will weaken the goal of building a solid retirement nest egg.

And, failing to make timely payments on the loans can have serious consequences. About half of 401(k) plans allow participants to borrow, according to the Employee Benefit Research Institute. Many plans allow employees to borrow up to half of their plan balance but no more than $50,000 in total.

Normally, borrowers get up to five years to pay the money back through payroll deductions. They also pay interest, often the prime rate plus one percentage point. Since you are paying interest to yourself, the interest proceeds become part of the employee's plan balance. In 2006, 18 percent of participants took out 401(k) loans. The problem with using your retirement plan as a short-term bank are not offset by the fact that you are paying interest back to yourself.

If you take loans because of money crisis, you likely will suspend making contributions during loan repayment, and you likely will have less money to work with when you retire. And, you may pay taxes and penalties if you default on the loan. If you leave your job, the loan on a 401(k) plan comes due immediately, typically within 30-90 days.

You can be charged federal and state taxes on the money you took out and a 10 percent penalty on the balance if you can't pay off the loan and are under 59 1/2 years of age.

You can also be charged with double taxation. Not only do you repay the loan with after-tax money, but you will be taxed again when you withdraw money in retirement. And, you lose the compounded interest that you would have received if you had left the money alone. If you don't contribute while paying off your loan, you will also miss out on the company match.

Over time, this is a big loss of return on your retirement plan.

Before you make a loan, consult with your financial adviser. If at all possible, look at other alternatives, and only consider a loan from your pension plan as a last resort.

Jim Lentini, CLU, ChFC, IAR is president of Lentini Insurance & Investment. His column represents his own views and not necessarily those of The Signal.

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