The Color of Money: U.S. Should Offer Tax Relief to People Who Borrowed From Their 401(k)

By Michelle Singletary
Thursday, August 13, 2009

As the Obama administration continues to look for ways to ease the financial pain that people are feeling in this recession, I hope it will provide relief for the many folks who are facing huge tax bills because of 401(k) loans.

For some, a 401(k) loan can be an appropriate bailout during difficult times. After all, you're borrowing your own money from your retirement plan and paying it back in monthly installments over five years, unless the loan is used to buy a primary residence. Plus you are paying interest to yourself -- typically the prime rate or prime plus one percentage point.

But if you leave your job, either voluntarily or through a layoff, the loan becomes due within 90 days. If you default, it will be costly.

First, the loan amount is subject to federal and state income taxes because the loan disbursement is considered taxable income. Remember, when you put money into a 401(k), it is not taxed. On top of the taxes due, if you are younger than 59 1/2 , you have to pay a 10 percent penalty for early withdrawal.

For a laid-off worker with no immediate job prospects, the penalty and pending tax bill can be financially devastating.

With all the temporary measures flying through Congress, it seems logical and compassionate to give a reprieve -- if only temporarily -- to employees who took out 401(k) loans and now can't pay them back.

In a report earlier this year, the Federal Reserve said that in its 2007 Survey of Consumer Finances, the share of eligible households with 401(k) loans was about 15 percent.

Interestingly, the Fed report, "New Evidence on 401(k) Borrowing and Household Balance Sheets." breaks with conventional wisdom that it's always a bad idea to borrow from your 401(k). Fed economists Geng Li and Paul A. Smith contend that tapping your retirement money can be a better move than using high-cost consumer credit.

The economists estimate that households could have saved as much as $5 billion -- or about $275 a year per household -- in 2007 by shifting expensive consumer debt to 401(k) loans.

"We find that many loan-eligible households carry relatively expensive consumer debt that could be more economically financed via 401(k) borrowing," they wrote.

I generally try to dissuade people from borrowing from their retirement funds unless it's absolutely necessary. When you pull money out of a retirement account, you lose whatever return you might have gotten on the portion of the cash not yet repaid. And although employees have seen their 401(k) balances drop by 30 percent or more recently, over the long haul portfolios have traditionally shown gains.

If that's not a good enough reason, then how about the risk of losing your job and having to pay back the loan in a short time? That's a real possibility for many workers in this economy.

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