Borrowing from 401(k) plan can lead to many short- and long-term pitfalls

Your Money

April 17, 2005|By Matthew Lubanko

I borrowed $4,500 from my 401(k) plan last year. Earlier this year my company cut me loose in a major downsizing. In addition to telling me I no longer have a job, my company told me I had to pay back my 401(k) loan within 60 days. Is that true? And what would happen if I decided not to pay back that $4,500?

J.S., Baltimore

You've accidentally discovered one major pitfall of borrowing from your 401(k) plan.

Your employer, under the law, can require you to pay back the loan within 60 days if you've left the company for a new job; if your company lays you off to reduce costs; or if your company fires you for misconduct.

A 401(k) loan, as a result, can prove costly in the short term and the long term.

If, for example, you fail to repay the loan within the required 60 days, the Internal Revenue Service will treat the unpaid balance ($4,500 in your case) as a "distribution." A distribution from a 401(k) - assuming your retirement savings were completely funded with pretax income (most plans are) - is taxed as regular income.

If you're younger than age 59 1/2 , the distribution is also slapped with a 10 percent penalty, said Tim McCoy, principal with the retirement plan marketing division at Edward Jones & Co. in St. Louis.

The costs of your 401(k) loan would neither begin nor end with taxes and IRS-imposed penalties, said Richard Sanchez, a director of national sales for Morgan Stanley's client coverage group.

A 401(k) plan is often your principal means of saving for retirement. When you borrow from the plan, you are removing relatively cheap pretax dollars. When you repay the loan, you're using comparatively expensive after-tax dollars, Sanchez said.

By removing money from the savings plan, you are also losing the benefits of your money growing in a tax-deferred shelter, sometimes for many years.

"You can replace the $4,500 in cash if you repay the loan. But you cannot replace the years of lost compounding interest," McCoy said. That same $4,500 would generate about $1,500 in interest income if that sum earned a 6 percent annual rate of return over five years.

In your March 27 column relating to a common question (Should I liquidate an asset to pay off a debt?), you forgot to mention that withdrawals from an IRA are a taxable event. Could you please correct this?

K.P., Chicago

I obliquely touched on this subject when I urged readers to calculate "the after-tax value of assets they might have to liquidate to reduce or extinguish debt."

If the concept of "after-tax value" of an asset is not clear to you and others, I will try to be more precise. So let's illustrate after-tax value with a few hypothetical examples:

A money market mutual fund with a balance of $100,000.

A stock worth $100,000 (and held for more than one year), with a cost basis of $35,000.

An IRA worth $100,000 in which all contributions were deductible.

A variable or fixed tax-deferred annuity worth $100,000, for which the owner paid $25,000 in premium at the outset.

Each has a face value of $100,000. But each, if liquidated to repay debt, would deliver different amounts of cash to their owners; each would have a different after-tax value.

The $100,000 in the money market fund is simplest. It is worth $100,000 after taxes. All that is lost, if the money is tapped to repay debt, is interest that would have been earned if the cash had been left in a money market fund, experts said.

The stock sold at $100,000 - with a cost basis of $35,000 - would face a capital gains tax on the appreciation of $65,000 ($100,000 minus the $35,000 cost basis). That $65,000 gain would be taxed at a rate of 15 percent (or $9,750); for lower-income taxpayers (who would probably move to a higher bracket with a $65,000 capital gain), capital gains are taxed at a 10 percent rate. That stock's after-tax value, in most cases, would therefore be $90,250.

"Capital gains on the sale of collectibles such as coins or stamps would be taxed at a different rate, 28 percent," said William Saas, a certified public accountant with Saas, Kirwan & Associates in Wallingford, Conn.

A $100,000 withdrawal from an IRA (if the IRA was funded with tax-deductible contributions) would be taxed as ordinary income. Ordinary income falls into several brackets: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent. The higher your income in 2004, the higher your tax bracket, and the more tax you'd pay on your withdrawal from an IRA. Assuming the tax brackets are static numbers, a $100,000 IRA would have an after-tax value ranging from $65,000 to $90,000, accountants said.

Tax-deferred annuities (held outside retirement plans) often follow an "earnings first, premium second" formula on withdrawals, unless the owner takes so-called annuitized payments, said Charles DiVencenzo, a vice president for advanced product marketing at Hartford Life Inc. in Simsbury, Conn.

In the hypothetical case above - a $100,000 annuity that's a product of $75,000 in earnings and $25,000 in paid premium - the first $75,000 withdrawn would be taxed as ordinary income. The last $25,000 withdrawn would be classified as "return of premium" and not taxed at all, DiVencenzo said.

The annuity's after-tax value would be $92,500 to $73,750. Only $75,000 would be taxed as ordinary income, at rates ranging from an unlikely low of 10 percent to a high of 35 percent.

Matthew Lubanko is a Your Money columnist. E-mail him at

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