For Gregg Simmons, the decision was a no-brainer.
Simmons, vice president of franchise administration for Metromedia Restaurant Group in Dallas, borrowed about $20,000 in 1988 from his 401(k) retirement savings plan at his former job to pay off bills. He had about $40,000 in his nest egg, and it seemed like a good idea at the time.
“It just made more sense mathematically to borrow against my 401(k) and pay myself 8 percent versus paying someone else 12 percent,” he said.
Many people think along the same lines as Simmons.
About 20 percent of 401(k) participants have a loan against their savings plan, said Bruce Mamary, a principal at Buck Consultants in Dallas, an employee benefits consulting firm.
“Where we see an increase in participants is when we make it easier to get a loan,” he said. Many companies are enabling employees to get a 401(k) loan by merely entering their personal information over a special interactive telephone line or by applying on a Web site.
But financial planners frown on 401(k) loans, saying that tapping that sacred money would be mortgaging a person’s future.
“I’m against it because I feel like you’re borrowing from your retirement,” said Joan Peurifoy, a certified financial planner and regional director at Financial Network Investment Corp. in Dallas. Financial advisers have worked hard at trying to persuade employees, especially younger ones, to participate in 401(k) plans offered by their employer. One attraction is that money in the account grows tax deferred until the employee withdraws it at retirement. If the employer matches an employee’s contribution, it bolsters the argument for participation.
Many 401(k) nest eggs have swollen to the point where they’re an employee’s largest asset.
Almost 10 percent of employees in 401(k) plans have balances exceeding $100,000, according to a January report issued by the Employee Benefit Research Institute in Washington, D.C., a non-profit research organization focusing on employee benefits.
But all those years of saving could vanish in a nanosecond because about 70 percent of employees cash out the money when they leave their job, taking a tax hit.
“It’s clearly got a troubling aspect to it,” said Dallas Salisbury, institute president. “The problem is, to the degree that individuals borrow the account balances and then change jobs, generally an individual has to pay off the loan at the time they change jobs.”
In a rising stock market, the most damaging consequence of taking out a 401(k) loan is slowing the compounding growth of money, a concept financial planners call the “time value of money.”
“When you borrow from a 401(k), you’re losing that momentum toward your retirement goal,” said Anne Marie Guerriero, investor education specialist at the Financial Literacy Center in Kalamazoo, Mich., which provides educational materials to employers and financial professionals.
The time value of money has taken on more importance with the stock market’s seemingly endless upward trajectory. What’s more, the tax-deferred status of 401(k) money makes the benefits of compounding more valuable.
“The time value of money is only relevant in a rising market,” said Douglas Gill, a certified financial planner and president of Gill Capital Management in Dallas.
Like Simmons, many people feel that it’s better to borrow from their 401(k) and pay themselves back with interest, than to repay someone else.
But financial planners said people miss a key point.
“You can’t equate the cost of borrowing from someone else with what you would be paying yourself in the 401(k),” Gill said. “Those numbers are not the critical point in this. The critical point is the loss of tax-deferred compounding.”
It gets worse if a person defaults on a 401(k) loan because the tax man then inflicts a painful bite. The Internal Revenue Service then treats the unpaid loan balance as a distribution and taxes it as if it were income. In addition, an employee who is younger than 59 years old is stuck with a 10 percent penalty for early withdrawal of funds.
“I don’t normally recommend them (the loans),” said Ted Benna, president of the 401(k) Association in Cross Fork, Pa., which represents 401(k) participants. “One of the things that’s troublesome is not realizing that if they’re unable to pay the loan, they’re going to be stuck with having to pay tax on it.”
Taxes, penalties and a debt repayment can easily wipe out a 401(k) stash.
“People think they have all this money, but by the time they’re done, they don’t have anything that was in the account, plus they have to come up with even more,” Salisbury said.
In today’s no-guarantees job atmosphere, an employee’s sincerest plans to pay off a 401(k) loan can be derailed by a corporate merger or acquisition.
Employers typically require employees to repay 401(k) loans in five years. However, if an employee leaves for a new job and he’s got a loan outstanding on his 401(k), he has to pay off the entire amount.
It’s not uncommon for companies to terminate a current 401(k) plan after a merger or acquisition and require an employee to repay the balance of a loan all at once, said employee benefit experts.
“If you’re going to borrow, you shouldn’t do it unless you expect to be with the company long enough to repay it,” said Benna, who has been credited with creating the 401(k) concept.
In Simmons’ case, Metromedia bought out his former employer and the old 401(k) plan was terminated, requiring him to repay the entire balance, which totaled about $15,000. He paid $5,000 on it, leaving a $10,000 balance.
“At the time that it happened, I was not in a position to pay back the loan, so the balance owed at the time of conversion was reported to the IRS and I had to come up with about $3,000 of income tax and a 10 percent penalty,” Simmons said. “Also, because this transaction was not taxed during the year, and I paid with the filing of my return, I was hit with an additional tax penalty for underpaying my taxes.”
Altogether, the unexpected events cost Simmons about $4,300 in taxes and penalties.
“The moral of this story is avoid borrowing from your 401(k) at all costs,” Simmons said. “While there may be circumstances that would make borrowing from your 401(k) more attractive than going to a bank, consider the consequences if your plan is canceled. It cost more than I certainly thought it could.”
Patti Bert, a Dallas human resources consultant, borrowed about $11,000 from her $24,000 401(k) as a down payment on a house. Then her former employer eliminated her department and laid her off. She was stuck with paying a balance of about $10,500 all at once. Fortunately, her severance benefits covered the amount. “Otherwise, I’m not sure what I would have done,” she said.
There are alternative sources of cash besides a 401(k) loan. A home equity loan can be used to consolidate debt, and the interest is tax-deductible under certain conditions.
First-time homebuyers ought to check out various loan programs offered by banks and thrifts that will allow them to buy a home with little down payment.
But sometimes, there’s no other option than to borrow from a 401(k) plan.
If you do that, pay it back as soon as you can so that your money has more time to compound.
“People need to understand that that tax-deferred compounding is so precious,” Gill said.
