I received the following email over the weekend:
Your article on 401(k) loans was very informative.
I am trying to decide between 401(k) loan and withdrawal. My 401(k) is not currently active, meaning I do not contribute anything towards it. I have moved to a new employer and my 401(k) was with the old employer.
I am looking to arrange funds for about 10K. I would be grateful to you if you could let me know which option is better?
First off, you can’t take a 401(k) loan from a 401(k) with a former employer. Had you had an existing loan on your 401(k) when you left your previous company, you would have had to either pay it back or pay taxes and a 10% penalty on the outstanding loan balance.
Now, it might be possible to move your old 401(k) into your new company’s 401(k). Then, it might be possible to take out a loan through your new company. You’ll have to check with your new company’s human resources manager to find out the specifics.
I don’t recommend the withdrawal route because you’ll be taking a 30% haircut on the withdrawal (20% withholding plus a 10% penalty). On a $10,000 loan, you’re looking at losing $3,000. That’s a lot of money.
One last thing I want to address is your reasoning for withdrawing money from your 401(k) in the first place. You don’t mention your reason in the email. I hope it’s for a good reason (perhaps to purchase a house). By withdrawing money now, you are forfeiting future growth on the withrawal, which could be significant. At least with a 401(k) loan, you are paying yourself back in a relatively short time period.
My recommendation is that you try to find the money some other way if you can’t do a loan. If there’s any way possible to avoid withdrawing funds from your 401(k), go that route.
Today’s Wall Street Journal had a short article about 409(k) debit cards. Jeremy over at Generation X Finance hates debit cards for 401(k) plans. I agree with Jeremy: it’s probably close to the worst idea ever!
I don’t think we should do anything that encourages people to borrow from their 401(k) plans. That said, the WSJ article did mention a couple of advantages to the debit card:
The debit card aggravates that problem, but it has advantages and disadvantages versus standard 401(k) loans.
For starters, the ReservePlus card is flexible; it can be used multiple times, for any purpose. As with a typical loan, employers set a borrowing limit based on how much you have saved for retirement. By law, the upper limit is generally $50,000 or 50% of your account balance, whichever is less. The approved amount is set aside in a money-market fund and earns tax-deferred interest until you use the card.
With every transaction, you have five years to pay back the money, and the interest rate — now about 8% — may be better than certain people can get elsewhere.
One advantage of a debit card is that if you are laid off or leave the company, there may be no pressure to reconcile the debt immediately. With a typical 401(k) loan, the outstanding amount must be repaid in full, usually within 90 days. Otherwise the loan amount is considered a taxable distribution.
One thing the article doesn’t mention is the cost of borrowing. Usually these loans come with some sort of fee. The interest rate is paid back to the participant’s account (you are essentially paying yourself interest) on an after-tax basis.
Still, despite the advantages, I think 401(k) debit cards and loans are a bad idea. What do you guys think? Have you ever used a 401(k) debit card? If so, what was your experience?
Here’s today’s question(s) of the day:
Do you think it is too easy for people to borrow from their 401(k) plans? Have you ever borrowed from your 401(k)?
My wife and I have borrowed against her 401(k) when we bought our house in 1999. This was back in the day when her 401(k) was our only source of meaningful savings. Although it worked out well for us, I can’t say that I would recommend it for everyone.
What about you?