Should you tap your 401 in an emergency? - k - Finance - Brief Article

USA Today (Society for the Advancement of Education), April, 2002

You or your spouse have just been laid off and money is tight. There sits your 401(k) plan, plump from several years of good returns, even after the current market slide, waiting for you to use it. Resist the temptation, say many financial planners. Taking money now from your retirement account to pay immediate bills is robbing your financial future.

Before dipping into your retirement account for cash, explore alternatives, the Financial Planning Association, Denver, Colo., recommends. First, don't do anything hasty. You may get a new job more quickly than you think.

Second, cut household expenses as much as possible. If that doesn't bridge the gap between income and expenses, consider tapping into nonretirement financial sources such as taxable savings or money market accounts, cash-value life insurance, or taxable investments such as mutual funds or individual stocks or bonds. Weigh your options carefully before deciding. It might be better to borrow in some cases, rather than to sell some investments.

After all this, the 401(k) may still look appealing. Before tapping into it, be sure to keep these points in mind: You have two ways to use 401(k) assets for an emergency--take money out permanently or borrow. On permanent withdrawals, you will pay regular income taxes, presuming all the contributions in the account were pretax. You also will likely pay a 10% early withdrawal penalty on the money if you are younger than 59.5.

The obvious downside to taking money out permanently is that you can never put it back and the money can never again grow tax-deferred in the account to help pay for your retirement. This loss of tax-deferred growth could cost you thousands of dollars over the years.

That's why borrowing is usually the preferable option of the two if you must tap your retirement account. While not all 401 (k)s or similar employer-sponsored qualified retirement plans allow loans, the majority do. However, most employees will not be able to borrow from their employer's 401 (k) plan after they've been laid off. In fact, laid-off employees will likely be required to pay back within 90 to 120 days any outstanding loans incurred before the layoff.

Assuming you have access to your or your spouse's plan, you typically can borrow up to half of the account balance, though no more than $50,000. You may be able to borrow up to 100% if the amount in the account is small enough. With the exception of borrowing for a home, you must pay back the loan within five years in regular payments, at reasonable (roughly market) interest rates.

That is one of the good features of borrowing from your own retirement account--you are paying the interest payments to yourself instead of another lender.

The big risk with borrowing is that, if you fall behind on your loan payments--a distinct possibility if you are laid off--you could end up paying Federal, and possibly state, income tax on the portion of the loan that has not been repaid, plus that 10% penalty if you are younger than 59.5. This is because the Internal Revenue Service treats any unrepaid amount as an early distribution.

Even assuming you pay yourself back, you may still suffer what is known as an "opportunity cost." That means the investments in the account could have earned more money than the interest rate you are repaying yourself with. Furthermore, you are not really "earning" money in paying yourself back. You are using your own dollars out of cash flow, and those dollars could have been invested elsewhere. You also are paying back the loan with after-tax dollars. When you withdraw that money years after retirement, you will have to pay tax on it--again!