What are the “Potential Hazards and Risks” in borrowing from your 401(k) and Retirement Accounts?

People may find it tempting to dig into their retirement savings for a variety of reasons. These reasons include purchasing a new car, taking an exotic vacation, buying household furniture and of course other emergency reasons such as cash for medical treatment. Nevertheless, it is important to realize that making withdrawals from your 401(k) account may come with disastrous financial consequences. There are various implications associated with these withdrawals, including penalties, taxes, and loss of compounded growth. Most accounts do permit “hardship withdrawals” for certain purposes including medical expenses, funerals, or college tuition. But, these so called hardship loans are restricted by the IRS to the lesser of a maximum of $50,000 or 50% of the balance of the account. Clearly, a loan from your 401(k) appears to be more prudent than using a credit card because the interest rates on a 401(k) can be as high as 20% in today’s market, whereas a loan from a 401(k) can be as low as 6%. However, despite this apparent benefit, one should be aware that excessive withdrawals could have a lasting effect on your retirement savings.

What are some of the negative consequences associated with 401(k) withdrawals?

1.The Loan has stringent terms and conditions.
It is extremely important that a taxpayer fully understands the lending terms and conditions of a 401(k) loan. These terms are very strict and can be potentially very costly, so think twice before making any withdrawals and be sure that you will be able to meet the requirements and installments. Generally speaking, most borrowers are only given five years to repay the loan, if you lose or switch your job, the loan must be paid promptly usually within 60 to 90 days.

2.Taxpayer will lose compounded tax deferred growth.
A major disadvantage of taking money out of your 401(k) is the fact that you will lose compounded tax-deferred growth of the money. For example, if you make a $20,000 withdrawal from a $100,000 balance and the market climbs to 20% only the $80,000 amount would participate in the growth. The taxpayer would lose the potential growth on the $20,000 amount that was borrowed. In today’s declining stock market, it would appear very tempting to either withdraw the money from the plan or even fine tune your portfolio so as to reallocate your portfolio away from Equity into Fixed Income. The main problem with this strategy is that if you withdraw in a declining market or readjust your portfolio into Fixed Income, would mean that recuperating your losses will be even more difficult particularly if the market turns around later on.

3.Danger of not being able to repay the loan.
If the taxpayer is unable to repay the loan according to the terms and conditions, the IRS will classify the entire balance of the loan as taxable. The consequence is that the outstanding loan balance will be considered a premature taxable distribution subject to a 10% early withdrawal penalty (assuming if the taxpayer is aged less than 59 ½). To make matters worse, the entire taxable distribution would also be subject to the taxpayer’s ordinary income tax rate. Thus, if the taxpayer is at the 25% income tax bracket, his total tax rate on the premature distribution would be a total of 35% tax rate (sum of the premature 10% penalty plus the 25% ordinary tax rate) on the taxpayer’s federal income tax return. This can be financially disastrous as the taxpayer may not have the means to pay the potential tax penalty.

In conclusion, I caution taxpayers not to borrow from their 401(k) to satisfy their personal indulgences such as vacations or a new car. Of course, for medical emergency one would not have a choice, but taxpayers need to be aware of the importance to repay the loans to avoid the disastrous tax consequences mentioned above.

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