Savings Interrupted: Warn Staff About Draining 401(k) Plans

By Sharon Severson

Without question, these are serious financial times. As more people find themselves unemployed, underemployed, or otherwise strained to meet their financial obligations, they may be tempted to tap into their retirement savings.

While borrowing from a 401(k) retirement account may seem like an easy path to fast cash, the long-term ramifications of withdrawing money from the plan make this an avenue of last resort.

Although each individual’s circumstances are different, taking a loan against 401(k) retirement savings carries the same risks for each participant—most notably the financial penalty associated with the loan. However, there are other important reasons why borrowing from a 401(k) plan can be a bad idea:

* Savings interrupted. The reason to have a 401(k) plan is to save for retirement. Chances are, participants taking loans from their 401(k) accounts may not feel they can contribute to their plan again until the loans are repaid. This interrupts the savings and defeats the purpose of the account.

* Lost interest equals lost money. Despite current economic times and the low interest charged for 401(k) loans, the funds withdrawn from the plan no longer earn interest based on market fluctuations. The participant loan should be viewed as a fixed investment as opposed to the equity investment of a 401(k) account.

Regardless of market conditions, serious consideration should be given before moving money from equity investments to a fixed investment.

* No more tax shelter. Under most 401(k) plans, borrowers must repay the loan within five years unless the money is used to purchase the participant’s primary residence (which allows a longer repayment period). Missing a payment may subject the borrower to a 10% early withdrawal penalty if younger than 59.5 years old, as well as ordinary income taxes on the unpaid balance.

* Time matters. Long-term investing uses time to the saver’s benefit. The longer money is invested, the more it will grow.

When the market is performing normally, calculations suggest retirement plans double roughly every eight years. Again, times being what they are, these calculations may be inflated. Nevertheless, 401(k) plans are predicated on the notion that investments left alone will grow.

However, if funds are withdrawn, the time factor disappears and most borrowers won’t reach the total they would have had the savings not been interrupted.

* Employment handcuffs. Most 401(k) plans require loans to be repaid immediately if the borrower changes jobs. So even if conditions are such that a plan loan is an only recourse, the borrower essentially is required to keep his or her current position or risk having the loan called in full.

In addition to the tax, savings, and lifestyle implications of borrowing from retirement accounts, borrowing from a 401(k) plan violates the golden rule of personal finance: Pay yourself first.

This, coupled with the higher cost of living in retirement, helped buoy the popularity of 401(k) plans when they were introduced. Borrowing from the account ends—or, at a minimum, suspends—the savings plan and breaks the golden rule.

While each individual may feel there are good reasons for borrowing from a 401(k) plan, there also are serious consequences with clear evidence against taking this course of action.

Sharon Severson is director of retirement plan products at CUNA Mutual Group, Madison, Wis. Contact her at 800-356-2644, ext. 6245.