Raiding Your 401(k) Can Be Taxing

Tax Tips

If you’re finding it hard to pay your mortgage or reduce your credit card debt, you could be tempted to tap your 401(k) retirement savings.

Many 401(k) plans allow workers to borrow against their savings and, in effect, pay themselves back with interest within five years. A study by the nonprofit Transamerica Center for Retirement Studies found that employees taking loans from their plans jumped to 18 percent in 2007, from 11 percent in 2006.

Unfortunately, raiding your 401(k) will not only put a big dent in your retirement savings for the long term, it could cause you considerable tax pain in the short run.

Here’s why.

Say you have some pressing bills, so you take out a $10,000 loan from your $20,000 401(k). True, you won’t be adding to your retirement savings, but at least you’ve got some breathing room, and you’ll replenish your account within five years. At least that’s the plan.

Now let’s say that because the economy is slowing, you get laid off from your job. Most company plans require you to repay your 401(k) loan, typically within 60 days from your layoff – or your loan will become a “distribution.”

In tax parlance, that means that the IRS now considers your loan to be income, like your wages, and you have to pay taxes on it. So, even though you’ve probably spent the loan and you have no job, you owe taxes. If you’re in the 28 percent tax bracket, you could owe $2,800. And if you’re under age 59 1/2, you’ll also get dinged with a 10 percent penalty, or another $1,000.

Many 401(k) plans also permit participants to take what are known as “hardship distributions,” for such immediate financial needs as preventing a home foreclosure or paying for a burial. The money is withdrawn and not repaid.

You might expect from the description that taking money from your 401(k) in this manner would involve some financial mercy.

Nope. The same income taxes and penalty apply. You’re facing a big tax bill and the likelihood that it could take years to replenish your retirement savings.

Why do retirement plans let workers sabotage their savings this way? Financial experts theorize that if the plans didn’t allow for some kind of withdrawals, not many people would use them. Let’s hope that despite current tough times, few are tempted.

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