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1 Apr

Why Borrowing from Your 401(k) is a Bad Plan

Posted April 1, 2012 by debtfreefamilytree in Debt Snowball, Debtfree Wannabe, Emergency Fund.


Why Borrowing from Your 401(k) is a Bad Plan

You’ve worked earnestly at your job, and you’ve met the eligibility requirements for the 401(k) Plan. You started contributing a percentage of your paycheck to maximize your match. A year or two later, you hit a financial bump in the road and want to borrow against your 401(k). There are several reasons why borrowing from your 401(k) is a bad plan.

 

Lisa and Michael’s Story

Lisa is 45 years old and has appropriately $5,000 in her 401(k). Lisa needs $3,000 from her 401(k) because her family is experiencing a financial hardship. Overall, the family only has $500 in savings now because they are trying to pay their mortgage, pay their vehicle loan, pay their credit cards, save for their children’s college, and pay off medical bills for Michael, Lisa’s husband. Michael is out of work due to an injury he sustained when he fell off a ladder at home. Their family and friends have loaned them money, but they did not anticipate all of the added expenditures resulting from the accident. Lisa’s company matches 100 percent, up to 3 percent of her income, and only allows employees to borrow against employee contributions. Thus, Lisa can only borrow approximately $2,500. The investment company will charge her a $100 Processing Fee, and before the funds are disbursed, a 20 percent Income Tax and a 10 percent Federal Penalty would be assessed. If Lisa chooses to withdraw funds from her 401(k), she cannot make contributions for six months.

After $850 in fees, taxes, and penalties, Lisa would only be able to borrow $1,650.

Immediate and Heavy Financial Need

Now, before Lisa can borrow from her 401(k), she will need to meet the IRS’ definition of immediate and heavy financial need. According to the IRS 401(k) Resource Guide – Plan Participants – General Distribution Rules, “A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.” Additionally, you would need to quality under one of the following reasons to borrow from your 401(k):

  • Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care;
  • Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
  • Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents;
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;
  • Funeral expenses; or
  • Certain expenses relating to the repair of damage to the employee’s principal residence.

Lisa would be required to submit paperwork, such as Michael’s medical bills, to prove that she has an immediate and heavy financial need.

A Better Plan

Although the story of Lisa and Michael is fictional, you may know someone who owes debt or does not have a 3-6 month emergency fund. They need a better backup plan so they can avoid financial hardship. Consider the following steps:

  1. Stop contributing towards your 401(k). Even the IRS wants you to borrow elsewhere before you borrow from your 401(k).
  2. Start automatic transfers from your paycheck (or checking account) to a savings account. Start with 5 percent and increase it later when you have the means.
  3. Grow your Emergency Fund so you can be prepared for all types of financial hardships, not just those recognized by the IRS, such as unemployment.
  4. Pay off all of your debt using the Debt Snowball.

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