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In a slow economy, many workers find themselves strapped for cash on a regular basis. With banks increasingly reluctant to give loans and other alternatives often coming with high costs, one solution seems like it's tailor-made for those struggling to make ends meet: taking out a 401(k) loan.
But as simple as it may seem to borrow what's in essence your own money, it actually comes with lots of complications. Moreover, when things go wrong, they can go really wrong with a 401(k) loan.
Later in this article, I'll give you several reasons that 401(k) loans generally aren't a smart move. But first, let's look at why workers end up borrowing from their retirement accounts rather than using other options to get much-needed cash.
For those trying to borrow these days, there's a huge divide to navigate. Creditworthy customers continue to get flooded with credit card offers, mortgage refinancing offers, and other great deals on borrowing. Mark Zuckerberg's 1.05% rate on his 30-year adjustable-rate mortgage is perhaps the ultimate example of what's available for someone with perfect credit, but the hundreds of dollars in sign-up bonuses that card issuers JPMorgan Chase (NYSE: JPM ) , Bank of America (NYSE: BAC ) , and Citigroup (NYSE: C ) offer certainly qualify as attractive.
On the other side of the coin, though, those with poor credit have found it increasingly difficult even to get credit cards. If you're underwater on your mortgage, it's tough to refinance, even with government programs designed to help you. Meanwhile, payday loan operators EZCORP (Nasdaq: EZPW ) and First Cash Financial (Nasdaq: FCFS ) can give you early access to your money, but they usually come with hefty fees that can get some customers into even bigger debt trouble.
By contrast, 401(k) loans can be relatively cheap and easy. Rates vary, but with many plans using the prime rate as a reference point, low interest rates make the self-financing option of 401(k) loans look attractive by comparison. And getting a check is often as easy as walking into your HR department and filling out a form. With nearly one in five workers having 401(k) loans, they've definitely become a popular borrowing alternative.
The downside of 401(k) loans
Recently, though, people who've taken out 401(k) loans are finding it more difficult to pay them back. According to a Brookings Institution and Navigant Economics study reported by CNNMoney, default rates on 401(k) loans have skyrocketed from 9.7% before the recession to a projected 17.4% recently.
At first glance, defaults on 401(k) loans may seem like nothing more than an accounting entry. After all, if you default on a loan to yourself, it seems like you should be able just to cancel the entire thing and call it even.
But the problem comes in with the mechanics of how 401(k) loans work. When you default, your employer takes out money from your 401(k) plan balance. According to the study, defaults on 401(k) loans are reducing retirement savings by up to $37 billion a year.
The IRS, meanwhile, treats the default as a taxable event. Therefore, you'll end up having to pay tax on the money your employer takes to cover the loan, and unless you're older than 59 1/2, you'll owe a 10% penalty on top of that. For those who are already scrambling to make ends meet, those penalties aren't easy to cover.
The worst situation happens when a 401(k) loan recipient gets laid off. If you lose your job, you immediately have to repay your full outstanding loan balance within 60 days, no matter what the original payment terms were. That's a cruel double-hit to those who've just loss their primary source of income.
Just say no
401(k) loans seem like an attractive solution, but they carry a lot more pitfalls than you might realize at first. Given how little control you have over the way 401(k) loans work, you may be better off choosing an alternative that's more costly in the short run but leaves you as the master of your own destiny when it comes to paying it back.
401(k) plans aren't for loans; they're for investing for retirement. If you need help getting your investments moving forward, you can get some ideas for stocks you can trust for the long haul from the Fool's special report, "3 Stocks That Will Help You Retire Rich." Get your free copy today while it lasts!
Meanwhile, if you think credit card companies are still a smart bet because of their high-interest lending, be sure to check out our premium investment report on Bank of America to learn what our senior bank analyst's thoughts are on B of A and the entire banking sector.