401(k) Loan/Debit Card: A Bad Idea in General. But What if as Last Resort?

Posted by Sun on March 13, 2008
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401k debit card ATMEverybody agrees in general that a 401(k) loan or a 401(k) debit card is a bad, bad idea. For those of us who don’t have a guaranteed pension plan and can’t rely on social security, 401(K), as well as other individual retirement savings accounts, is one major tool to save for retirement when our pre-retirement incomes stop.

Since the money in the 401(k) account is for retirement, not for daily expenses, the government imposes an extra 10% penalty to discourage early withdrawals from the account. However, as the credit crunch goes on and home value keeps falling, more and more people start to have a hard time paying their bills or face losing their homes to foreclosure. At the same time, the cost of living is going nowhere but up: food, gas, health care, education, etc., things are getting expensive. Then there comes the creative idea of using a 401(k) debit card to borrow money from retirement accounts such as 401(k) to stay afloat, just like withdrawing cash from your private ATM machine.

I recently read quite a few articles on how a growing number of people are taking money out of their 401(k) accounts to save their homes. For example, in this USA Today story, Tamara Campbell, who lives in a Denver suburb

raided her 401(k) after her husband was laid off from his job as an occupational technician, and they fell behind on their mortgage for several months. “If I hadn’t done that, we would have been foreclosed on last year.”

Late last month, The Wall Street Journal reported that a survey among 2000 full-time workers conducted by Transamerica in 2007 found “49% of those who borrowed from their retirement savings said they took the loan to pay off debt, up from 27% in 2006.” And there are strong correlation between foreclosure rates and 401(k) loan or hardship withdrawal rates in regions of country where home prices are hit hard.

And for those who took money from their 401(k) accounts, not only they have to pay penalties and interests, but also could face shortfalls when they retire. Take a look at this example from The Wall Street Journal:

A participant with a $20,000 account balance who contributes $100 a month and earns an annual return of 10% would have $624,681 after 30 years. But if that participant borrows $10,000 from his plan and repays the loan at 7% interest over five years, halting contributions while he repays the loan but making $100 monthly contributions for the next 25 years, he would have only $523,502 at the end of the 30-year period.

Despite all the serious consequences of withdrawing from 401(k) accounts, if you are in a situation that you could lose your home if you can’t keep up with your mortgage payments, but have, say, $100K in your 401(k) account, would you withdraw from your 401(k) to save the roof under which you and your family live?

I would, as a last resort.

If that’s what you decide to do, then take this advice from The Wall Street Journal article:

If participants decide they must take out a 401(k) loan, they should aim to pay it off as quickly as possible and continue making new plan contributions while paying off the loan, taking full advantage of any employer-matching contributions.

Just like paying any debt requires responsibility and discipline, the same applies to 401(k) loans but with increased urgency.

Creative Commons License photo credit: lomorajue

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4 Comments
March 13, 2008

When it comes to an emergency or last resort, there is nothing wrong with borrowing from your 401k. That is why most plans have loan and hardship provisions.

With a hardship, you actually have to qualify by being faced with a clear set of criteria that proves it is a hardship. Unfortunately, loans don’t have this, and oftentimes you can simply call your provider or send in a form to borrow money no questions asked.

This is where you have people who end up tapping into their retirement fund for purchases that aren’t threatening the ability to put food on the table or shelter over their heads. Instead you have people taking vacations or buying Christmas presents with their retirement funds.

And the easy access that a 401k debit card will provide just makes this even worse.

Posted by Jeremy
March 18, 2008

On the otherhand, I get the feeling that many people raiding their 401Ks to “save their homes” will only get a temporary reprieve. You have to be realistic — is this just a temporary situation you can bounce back from? Or were you just a fool for buying too much home with some exotic loan and can’t afford the regular payments? If so, using 401K money only leaves you in the same position a few months later except with an empty 401K account and taxes owed (if you can’t pay back the loan). Might as well run on the credit cards, declare BK and leave your 401K assets protected.

Posted by MossySF
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