Borrowers Beware: 401(k) Loans Hold a Hidden Risk

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The difficult economy of the past few years has led many people to take desperate measures with their money. Unfortunately, some of the things people have had to do to make ends meet in the short term are creating financial problems for them in the longer term.

But one group is looking to change that in a key area that has tripped up millions of American workers.

Insurance provider Custodia Financial recently created a website to inform workers about the danger of defaults on 401(k) loans. Before turning to its solution, though, let's look at the scope of the problem.

Borrowing From Your 401(k)

We all know that it's important to set aside money for our retirement years. But when times are tough, many people don't have the option of thinking about what's going to happen to them decades down the road.

As a result, roughly 15 million borrowers have tapped their 401(k) retirement plan accounts for funds to meet their current expenses.

At first glance, borrowing from your 401(k) seems like a smart move. You don't have to go through an arduous application process, you won't get turned down, and interest rates are typically low compared to the alternatives. Perhaps most attractively, the interest you pay goes back into your retirement account, so in effect, you're paying interest to yourself.

Dangerous Debt

Unfortunately, the benefits of a 401(k) loan come with a catch. If you lose your job, you have to pay your loan back within 60 days. If you don't repay, then the loan goes into default.

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That's a significant problem, as Custodia says that 10% of all loans default due to unemployment.

Defaulted 401(k) loans not only shortchange your retirement savings, but the IRS treats the default as a distribution of retirement assets to you. As a result, you'll have to pay tax on the amount of the loan, along with any penalties if you don't meet the age requirements for a distribution.

An Answer?

That's where Custodia hopes to come in. The company supports legislation that would allow employers to automatically offer credit insurance to 401(k) borrowers that would take care of repaying their outstanding loan balance in the event of death, disability, or involuntary job loss.

Such protection already exists for other types of loans, including mortgages and credit cards. But without express provisions in the laws governing retirement plans, employers have been reluctant to turn to credit insurance protection for 401(k) loans.

The proposed Retirement Savings Security Act would give employers the comfort they need to offer products like this.

The Price of Protection

The unanswered question, of course, is how much such protection would cost.

Similar coverage for outstanding credit card balances can get extremely expensive, with one card charging $0.85 per $100 each month for unemployment protection. Applying a similar insurance premium rate to a $10,000 401(k) loan would force workers to pay $85 per month for credit insurance -- an amount that few struggling workers will want to pay to access their own retirement money.

The 10 Worst States for Retirees in 2012
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Borrowers Beware: 401(k) Loans Hold a Hidden Risk

High property taxes and a high foreclosure rate weigh heavily on Wisconsin. On the other hand, Social Security income is exempt from its income taxes (which are also high).

Ninth place was virtual tie, but Maine offers lower property taxes than the No. 8 state. It does, however, have higher income taxes. The governor has said he wants to make retirement income tax-exempt in Maine, but it hasn't happened yet.

New York wins (or, rather, loses) the toss-up with Maine because of its median property taxes -- the fourth highest in the nation -- and general tax burden. Generous exemptions for Social Security and pensions, as well as a high standard deduction, count in the Empire State's favor. Cost of living, of course, and the bitter winters are heavy strikes against New York -- unless you're rich, or a member of the Polar Bear Club.

With no income tax exemptions for pensions or Social Security, Minnesota puts a heavy tax burden on retirees -- the nation's fourth highest levy, according to TopRetirements's calculations.

The blight in the Garden State: taxes. New Jersey levies the nation's highest median property tax ($6579), and has the highest income tax burden as well, according to the Tax Foundation. On top of that, it's facing a big budget deficit, and features a lofty cost of living. But most pension and Social Security income is tax-exempt for couples making less than $100,000.

The Bay State is often called "Taxachusetts," and with good reason: Property taxes are among the nation's highest, and the flat rate applied to earnings beside Social Security, which is exempt (like government pensions, but not private ones), can prove costly indeed.

The Green Mountain State may be scenic, but it harbors high median property and income taxes, and its cost of living is in the top 10. Winters are described locally as "too cold to snow."

Rhode Island's scenic too, but is facing choppy economic waters, with underfunded pension and health care liabilities, as well as budget deficits. This despite the fact that the Ocean State has the fifth highest median property taxes paid.

The Prairie State is in dire fiscal straits, with terrible figures for pension funding, deficit spending, unemployment and foreclosures. The official response out of the capital in Springfield? An increase in income taxes. Most pension and Social Security income is not taxed in Illinois, but the state's 5% flat tax eats into other earnings, such as investment income.

Locked in a dead heat overall with No. 2 Illinois, Connecticut won its spot at the top of the list because of higher property and income taxes, as well as a greater cost of living.

Moreover, the coverage for credit card unemployment insurance tends to be less comprehensive. For instance, rather than paying off the entire card balance, one program only makes monthly payments of twice the required minimum for up to 18 months. Coverage that would entirely repay an outstanding 401(k) loan balance would presumably be more costly, although the higher amounts involved might allow insurance companies to offer discounts.

Think Twice

For now, few employers are likely to offer the protection that Custodia would provide without express guidance from the government. But the point every worker considering borrowing from their 401(k) needs to understand is that if you don't take steps to protect yourself, a layoff could put your retirement assets at immediate risk. And that makes 401(k) loans a lot less attractive than they might appear at first.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger.

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