By Michael Cecere, CPA, MST
Gray, Gray & Gray, LLP
In the challenging economic times we are currently experiencing, individuals seeking to supplement or replace lost income, or to get through financial crises such as unemployment and medical emergencies, have taken to “raiding” their own 401(k) plans. This is a fiscally risky move that could have serious consequences, both in the short term and down the road.
401(k) loans have long been an option for emergency borrowing, or for providing funding for significant purchases, such as a first home. With a 401(k) loan you are essentially borrowing from yourself. Such loans are generally short term and are paid back automatically through payroll deduction of the loan premiums.
In most cases, borrowers can repay loans within five years without penalty. Loans for first-time homes must be repaid within 15 years to avoid penalties. Failure to repay loans on time typically incurs a 10% excise tax penalty as well as income tax on the unpaid balance.
The number of 401(k) loans has risen dramatically in recent years. A study by the Center for American Progress found workers in 2004 had $31 billion in outstanding 401(k) loans, a fivefold increase from $6 billion in 1989. Between 1998 and 2004, an average of 12% of families with 401(k) plans had borrowed from them.
The down side of a 401(k) loan is the money you borrow is not earning as much interest while it is out “on loan.” This is particularly troubling at a time when Social Security is in trouble, pension plans are disappearing, and personal retirement savings accounts are expected to play a more prominent role in providing retirement income for many Americans. According to the Center for American Progress study, a $5,000 loan could cut retirement savings by 22% even if the loan is repaid without penalty.
It gets worse. Several financial institutions have introduced a 401(k) debit card. If you want to make a purchase and don’t have the cash on hand, you can simply swipe your 401(k) debit card and instantly “borrow” against your retirement fund.
Unlike a 401(k) loan, which is paid back through payroll deductions, the user of the 401(k) debit cards gets a monthly bill, just like a credit card. If you can’t come up with the money to pay the bill, you could default on the “loan” from your 401(k) and get hit with the penalties and taxes for early withdrawal.
Individuals who are enamored of the ability to withdraw or borrow funds from their 401(k) are missing the point. The 401(k) is set up for their retirement, not their current expenses. Being able to easily tap into that pool of money can be a big temptation — too big for many people. As a result, they are compromising their future security.
Naturally, if there is a true emergency a 401(k) loan, used wisely, can be an advantage. But dipping into the cookie jar for transient purchases — like a new car, vacation or plastic surgery — is a huge risk that may jeopardize more than your retirement.
Michael Cecere, CPA, MST is a Gray, Gray & Gray partner. He can be contacted by telephone at (781) 407-0300, or via email at: mcecere@gggllp.com.