Borrowing Against Retirement Accounts Hits New Highs

Cassandra Hubbart,
Cassandra Hubbart,

Like a tree laden with ripe summer fruit, plump 401(k) accounts can appear as tempting sources for an easy loan, especially when other financial resources have dried up. And more people than ever have been plucking from that tree.

Loans against retirement plans were up overall last year, with one in seven workers borrowing money, according to new data from human-resources consulting group Aon Hewitt. Fidelity Investments told DailyFinance that it saw an increase in 401(k) loans over the last few several years, but reported a slight decline in the last quarter for the company's 11 million plan participants.

TIAA-CREF, which is the largest provider of retirement plans for nonprofit organizations, reported to DailyFinance that loans against its plans were up nearly 19% in 2010 from the previous year, and there was a 7% increase in hardship withdrawals. Nearly 30% of all plans have a loan outstanding, the highest level in history, according to The Wall Street Journal.

"Within the industry, the number has increased because of the economy," says Dan Keady, director of financial planning for TIAA-CREF. "It can be a nice feature for some people who need loans for a specific purpose." But the challenge, he notes, comes when someone who is in real financial difficulty is unable to pay back the loan.

Glenn Hottin, a longtime financial planner with M&H Advisors in New Haven, Conn., says he has seen an increase in 401(k) loans over the last few years as other credit options tightened. But he emphasizes that such loans are "an absolute last resort and only when you have exhausted all other options, or those options just don't make any financial sense."

Getting Money From Your Retirement Plan

In general, employees who actively participate in a plan can take a loan from their 401(k) -- if their employer allows such loans -- without a credit check or much paperwork.

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They can borrow up to 50% of the balance up to a maximum of $50,000. General loans are paid back over a period of five years (10 or more for home-related loans) at a competitive market rate, and often are repaid directly from payroll. The interest paid on the loan goes back into the borrower's own account, and the specific terms of a loan are set by the plan sponsor or employer. States have different rules, so consumers should carefully check the guidelines that affect them.

Hardship withdrawals are another way to pull money out of retirement savings early, but they have stricter qualification standards and more stringent penalties. Typically, a hardship withdrawal can be obtained for medical or housing emergencies (see IRS guidelines), but the money is taxed as income, and a participant who takes one can't contribute money to his or her 401(k) plan for six months afterward.

'Am I Proud? No. But Am I Happy? Sure.'

Several years ago, Leslie Brown (not her real name) was overwhelmed with credit card debt, on which she paying 19% interest. Brown decided to withdraw $60,000 from her AXA retirement plan to get back in the black. "I hadn't had a raise in three years and it hurt," she recalls. "I needed a chunk of cash and I couldn't figure out any other place to get it."

The 51-year-old restoration architect says the withdrawal had a 13% penalty, plus a big tax. And it was a set back in terms of her retirement planning, leaving her with a total of $150,000 in her plan. Still, she says it was worth it to get the debt cleared. "Am I proud? No. But am I happy? Sure."

Today, Brown is still debt-free and trying to restore her retirement savings by contributing the maximum amount she is allowed.

Retirement and 401(k)s
Retirement and 401(k)s

Downsides to Drawing on Your Nest Egg

First and foremost, borrowing against your retirement fund deprives you of the benefit of compounded savings. Many financial advisers frown upon these kinds of loans because few people have the discipline to pay back the loan and build equivalent savings simultaneously.

Additionally, the loan's terms are contingent on the borrower maintaining employment with the plan's sponsor. Should you lose or change your job during the life of the loan, the outstanding balance is due within 30 to 90 days. Whatever you can't repay within that time is treated as a taxable distribution. For example, if you borrow $30,000 to help pay for college tuition and have only repaid $5,000 when you lose you job, the $25,000 outstanding is treated as a taxable distribution. Additionally, if your financial circumstances lead to a loan default, you're not only on the hook for the tax, but an additional 10% penalty.

"If the loan is taken for a valid reason like a down payment on a home or college expenses for a family member, then there may be some merit in taking it," says Gil Amour with SagePoint Financial in San Diego. "But I have seen too many people abuse the loan privilege and use the 401(k) account as an emergency fund whenever they get into trouble with credit card bills or ordinary household expenses."

When Might You Take a 401(k) Loan?

There are a few scenarios that tip the scale toward borrowing from your retirement plan if your employment status is very stable. For example, a 401(k) loan can assist in a bigger down payment for a primary residence that results in a better, tax-advantaged home loan. Other scenarios: Your retirement saving might be ahead of schedule, or you might have strategically over-funded a plan as a way to prepare for a major expense such as a child's college tuition.

"In a low-interest-rate environment like we have today, the opportunity cost of taking these loans is minimized somewhat," says Sean Kelleher, a financial planner with Riverchase Financial Planning in Lewisville, Texas. "In situations where a 401(k) loan is a viable option, I will typically instruct clients to only look at their fixed-income portion of their 401(k) as what they can use. This helps minimize the opportunity cost because the long term returns on the fixed income portion are typically lower than the equity returns."