Financial Freak Show

I was posed a question about using a 401k loan to clean up someone’s financial train wreck. The mess in particular was created by buying a bunch of junk that these people didn’t really have to ability to afford at the time but did have the ability to borrow. Now they’re trying to refinance their home to lower their monthly payments to get a little breathing room. The problem is they’re now a little upside down on the home and the bank wants them to bring some cash to the table before they will allow them to re-fi the house. So they’re considering a 401k loan to make this happen. That is until I laid out to them a little more insight into how these loans work.   

They would be allowed to borrow up to 50% of the vested balance with a maximum of $50,000. That should be okay in their case because they have a balance of near $65,000 and are looking to pull about $28k.

The money in their case would be available at a 6% interest rate. The interest does go back to your account but depending on the market performance this could be a losing deal as far as growth.

The loan sort of turn offs your 401k for a period of time while you work to pay back the balance. Well you don’t turn off the entire 401k but the portion you borrowed is no longer considered part of the balance so no growth will happen to the portion you have taken out of the account.

Here’s the big reason I think 401k loans should be used only as a last resort:

If you leave your company most plans require that the balance be paid back into the account within 60 days. This comes due no matter the circumstances of your departure, if you go “Jerry Maguire” on them and walk out the door with the hot receptionist you’ve got 60 days. If you decide to leave because things get a bit uncomfortable around the office after you’ve been fired, you have 60 days. If you’re unfortunate enough to die, 60 days. If the loan is not repaid within 60 days the remaining balance is considered an early withdrawal and you will have the pleasure of paying income taxes plus a 10% early withdrawal penalty (if you’re under 59-1/2). So for many families you’re looking at a full 30%-40% tax bill due on that money. So if my friends borrow the $28,000 they needed and it blows up in their face they are looking at writing a check for $8,400 to $11,000 conveniently right around the time they lose a job. Talk about crappy timing…oh, and add that to the fact that they had to borrow money so they obviously we’re already in a less than desirable situation before they lost the job! And remeber the IRS doesn’t like to wait around for their money.

So I’m not saying a 401k loan is not an option, in some cases it may be the only option someone has to save a house or avoid a bankruptcy. I just want to throw this out there so everybody knows what road they are heading down before they board the special bus.

What’s your experience with 401k loans? Please share.