The PROS and CONS of Borrowing Against Your 401(k) – (+5K Views)

Look, if you’re absolutely stuck right now, then you’ve got to do what’s necessary but, in my opinion, you should avoid 401(k) hardship withdrawals at all costs … and think long and hard before you consider borrowing against your future retirement. With so many people nearing retirement already grossly underfunded [such actions are] going to prove catastrophic down the line. Words: 1043

Lorimer Wilson, editor of www.munKNEE.com, provides below further reformatted and edited [..] excerpts from Nilus Mattive’s (moneyandmarkets.com) original article* for the sake of clarity and brevity to ensure a fast and easy read. (Please note that this paragraph must be included in any article reposting to avoid copyright infringement.)

Mattive goes on to say:

Fidelity reports that a record number of Americans are making hardship withdrawals from their 401(k) retirement plans (and, worse yet, those borrowing from their plans is also at a 10-year high!). [In addition to mortgaging their future retirement well-being such] withdrawals get assessed an additional 10 percent penalty besides the regular taxes [they must pay on the withdrawal amount as income in the year of withdrawal meaning that a large portion] of their nest egg money gets vaporized before it even goes toward their immediate needs!

PROS and CONS of Borrowing Against Your 401(k)
Fidelity said 45% of the people who took a hardship loan last year took ANOTHER ONE this year. On the surface it’s better to take a loan than an outright withdrawal because taxes and penalties aren’t assessed [the one and only PRO) but here are a couple of CONS:

#1. Unlike hardship withdrawals, there are no hard-and-fast rules on loans so there is no guarantee that this money is truly being borrowed for dire circumstances. People could simply be tapping their future retirements in the same way that they tapped their home equity a few years ago.

#2. While it is true that this money should ultimately be repaid, and at least the interest will go back to into the retirement account, it essentially means that very little new money will be contributed. The end result will be a lower final balance and the loss of the very tax advantages that make 401(k)s attractive in the first place.

How to Remove Money from a 401(k) Plan
The 401(k) plan is the most ubiquitous retirement account in the United States, and for good reason: Any money employees contribute is not counted for income tax purposes. Instead, it’s taxed — along with investment earnings — upon withdrawal. So how and when can money come out of a 401(k) plan?

1. Upon Retirement
Retirement is defined by the tax code as the contributor reaching age 59 ½. At that point and beyond, any money that comes out of a 401(k) plan is simply taxed as regular income.

2. Through Separation of Employment
In this case, the contributor has four choices, which boil down to:
a) Leaving the money where it is
b) Rolling it over into a new employer’s plan
c) Rolling it into an Individual Retirement Account
d) Withdrawing it.
When done correctly, the first three options don’t result in any taxes or penalties. However, the fourth option DOES (unless the employee also happens to meet the conditions for retirement discussed above).

In short, money that comes out of a 401(k) plan before the contributor reaches age 59 ½ results in both regular income taxes being due but ALSO a 10 percent early withdrawal penalty.

3. Hardship Withdrawal
While they’re not required to do so, most 401(k) plans allow contributors to remove money under certain circumstances — including medical expenses, the purchase of a principal residence, tuition and related educational costs, and funeral expenses. Individual plans have some leeway in how they specifically define “hardship” and what particular events can trigger withdrawals.

The IRS does provide the following guidelines:
a) “For a distribution from a 401(k) plan to be on account of hardship, it must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. The need of the employee includes the need of the employee’s spouse or dependent.
b) “Under the provisions of the Pension Protection Act of 2006, the need of the employee also may include the need of the employee’s non-spouse, non-dependent beneficiary.
c) “A distribution is not considered necessary to satisfy an immediate and heavy financial need of an employee if the employee has other resources available to meet the need, including assets of the employee’s spouse and minor children. Whether other resources are available is determined based on facts and circumstances.”

The IRS will:
a) not impose the 10 percent early penalty on these withdrawals in a few specific cases such as death, permanent disability, or termination of service after age 55 – but in most other cases it will
b) require payment of ordinary income taxes on the amount removed and
c) bar the individual from contributing any new money to any employer retirement plan for at least the following six months!

4. A Loan
Most, but not all, plans will also allow participants to take out loans from their 401(k) accounts. Generally, these loans have five-year terms — unless it’s for a primary residence — and carry fixed interest rates. Repayments must be made in regular installments, and everything goes back into the 401(k).

Conclusion
Think long and hard before you consider borrowing against your future retirement [because, with] the other typical sources of retirement income looking shakier than they ever have before, tapping your 401(k)s may find you completely out of options in your golden years.

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*http://www.moneyandmarkets.com/the-perils-of-tapping-a-401k-39976