Your 401k is not the place to borrow money
By TERRY SAVAGE email@example.com or @TerryTalksMoney September 12, 2012 6:42PM
Updated: May 3, 2013 12:15PM
Q. I’m thinking of borrowing from my 40l(k). I know you’ll say it’s a bad idea, but it’s my only option to keep
my family going. I already have credit card debt, and I’m trying to make my mortgage payments. Do you have a better idea, or anything else I should know?
A. It’s definitely NOT a good idea to borrow from your 40l(k) plan — even though you’re borrowing from your own money, and in effect, paying interest to yourself. You’re losing the growth that you could have earned on the money you withdraw. And one day, you’ll need that money for retirement.
But I suspect you already know that and don’t need a lecture from me! There are, however, a few more things you should know about retirement plan loans — information that could be costly if you ignore it.
A new report estimates that 15 million to 20 million Americans (which represents nearly a third of all eligible participants) have an outstanding loan from their retirement plan — amounting to more than $100 billion in loans. So you won’t be alone if you do borrow.
You will pay interest on the loan, at a rate that is typically set around Prime plus 2 percent. The interest and repayments go back into your account. And you have five years (60 months) to repay your loan.
The real danger
The real damage is done when a borrower cannot repay the loan — either because of disability or because of job loss. If you lose or quit your job, you have only 60 days to repay the loan. If you can’t repay it, the loan is considered in default. Then you owe income taxes on the amount withdrawn. Plus, if you’re under age 59½ , you’ll owe a 10 percent federal tax penalty!
Where will you get the money to pay this federal (and state) tax? You’ll probably have to take the remaining money out of your plan — generating more taxes and penalties! And then you’ll wind up with no retirement savings!
It’s estimated that between $10 billion and $37 billion in retirement savings is lost annually, as a result of “involuntary defaults” caused by unemployment, death or disability.
A new kind of insurance policy designed to protect employees from the consequences of loan default is now being offered directly to employers by CustodiaFinancial. CEO Tod Ruble says his company wants to encourage literacy around the true potential costs of 40l(k) plan loans. They’ve even set up a website, www.Protectmy40lkloan.com to guide plan participants through the financial issues involved with borrowing.
But ultimately, Ruble says, employers and plan providers have a responsibility to help their employees cover the risk of involuntary defaults. Plan participants can voluntarily opt in to use this insurance policy when they take out a plan loan. The cost is low because the loan interest rate on an insured loan can be reduced. The policy repays any borrowed money and interest, as well as any penalties incurred.
More info is at www.CustodiaFinancial.com.
So, my advice is realistic. Use your retirement plan as a last resort. And if you must borrow, make sure you understand all the expensive consequences of defaulting on a plan loan. That’s the Savage Truth.