This month’s message is short and sweet - don’t borrow from your retirement accounts. This may not seem like a significant issue but the fact of the matter is that the number of people borrowing from 401(k) plans doubled from 2005 to 2007 so lots of people do it.* Although most 401(k) plans make it easy for you to borrow, they don’t always make it completely clear that if you leave the company, for any reason, you’ll have to pay the loan back almost immediately. If, in the unfortunate circumstance you are leaving your job due to a layoff or firing, repaying the 401(k) could be very difficult as few lenders will lend to people who are unemployed. Borrowing from your IRA is even worse. While technically it’s not legal to borrow from an IRA, it is possible to withdraw the money from your account and hold it temporarily (effectively borrowing it) before you roll it into a new IRA account. The problem is the rollover period is short and chances are you’ll be hard pressed to get it paid back unless you are really conscientious.

The biggest problem with borrowing from your retirement account is that if you are late in meeting the deadline in paying back the loan, even by a day, the IRS will classify the full amount outstanding as a withdrawal and therefore a taxable distribution. This is particularly problematic for people under 59½ as you’ll get hit not only with the tax on amount you withdrew, but also with a 10% early withdrawal penalty. The combined burden of income tax and penalty means you’ll owe the IRS a considerable portion of the money you borrowed. Even worse, any withdrawals, whether on purpose or not, can not be replaced beyond your annual contribution limits so you’ll have forever lost the benefits of tax deferral on the money that’s withdrawn. The economic danger of borrowing from your retirement account is clear.

Still, some will argue that loans from retirement accounts may be a necessary evil if you’ve fallen on desperate economic hardship and have no choice. Perhaps, but consider that 401(k) accounts are protected from bankruptcy claims so if you’re headed into bankruptcy it may be better to file for bankruptcy a little bit earlier and try to preserve what you can in your retirement accounts. You’ve worked hard to accumulate your retirement savings, don’t risk it by borrowing from your account.

Randy Gridley

July, 2008