The 401k Layoff Trap

Gary — Tue, 31 Mar 2009 17:43:00 GMT

I was surprised at the "Borrow from your 401k" suggestion. While it's true that it's better than cashing out, so many people are being laid off unexpectedly. When this happens, it must all be paid back or considered a cash-out, which comes at a time when people are least able to repay because they just lost their job. It should at least have been mentioned as a consideration. -- Deborah in San Diego

Deborah makes a very interesting point. She's referring to an article entitled "Need Cash" that discusses 10 ways to raise cash quickly if you're in a jam.

How widespread is the problem? It's hard to find many statistics on 401k loans. But a Harvard report cites two statistics that point to trouble. The vast majority of plans allow for borrowing (over 85% in 2005, Investment Company Institute, 2006). And they also report that 18% of 401(k) participants had a 401(k) loan in 2006.

We can't know for sure, but it's probably not an unreasonable guess that about one in five or six people who are laid off will have a 401k loan outstanding when they get the pink slip.

And, that's when Deborah's problem comes in. As a general rule, if you leave your employer you need to repay the 401k loan in full. You may be given a month or so, but that's it.

Any amounts that you fail to repay are treated like a withdrawal. That means that you add the amount of the loan to your income and you'll pay normal income taxes on it. Plus, you'll be liable for a penalty that equals 10% of the unpaid loan.

What can you do about it? First, if you have a 401k loan and think that you could lose your job, you need to take it seriously. Begin by estimating how much the taxes and penalties would cost you if you didn't repay part or all of the loan. It'll be bad. But since your income will be lower than previous years (because of the layoff), your tax rate should drop (that assumes no tax rate hikes).

In any event, you need to have some idea of how much the penalties and taxes are. You'll want to compare that to the cost of other alternatives.

There are a couple of withdrawal exceptions that might help in a layoff situation:

You were age 55 or over and you retired or left your job
You paid for medical expenses exceeding 7.5% of your adjusted gross income

What if you don't fit into one of those categories? Your options are limited, but you still have some choices to make.

Now might be the time to consider selling a car. Your ride needs to be worth more than any loans on it. Any cash you raise could help pay off the 401k loan. If you're not working transportation won't be such a big issue. You can always buy another car when you're employed again.

Do you have a homeowner's line of credit or enough equity to refinance your home? That could provide some money to repay the 401k loan. Refinancing will be easier before you lose your job. So you might want to consider this if you expect to be laid off.

Using your credit card to pay off the 401k loan is a high-risk strategy. You'll probably pay a higher interest rate. And, you'll also need to keep making payments even if your income has dried up. Plus, you'll be consuming part of your credit line that you may need later.

The only advantage to shifting the debt to a credit card is that you avoid the tax problems of a 401k withdrawal. But it's wise to compare the numbers before you make a decision.

The unfortunate fact is that most 401k loans were promoted as an painless way to 'borrow from yourself'. Turns out that's not so true if times get tough.

Keep on Stretching those Dollars!

Gary

What? Me Worry?

Gary — Tue, 26 Feb 2008 15:20:00 GMT

Back when I was growing up Mad magazine was a favorite of kids. (maybe it still is). They had many regular features, but the best known was a character named Alfred E. Neuman. He wandered through life ignoring danger. And he introduced a whole generation of kids to the phrase "What, Me worry?"

Fast forward to 2008. I recently received the following email:

I am trying to help my nephew, who wants to buy his first house at the age of 51. He wants a $300,000 house, mortgaged for 20 years. But he and his wife declared bankruptcy (credit card debt) a few years ago, and though he is at the end of paying off his debit, he finds it hard to get a good mortgage deal. His best bet, I think, is to pay at least 20% down. But he has only $29,000 (an interest-free loan from me). Shouldn't he borrow from his 401K the rest of the 20% needed (they do have $31,000 in their 401K accounts)? Suppose he saves one-half a percent? Would that be worth it? (I do not know the details of the 401Ks, but let us assume some "typical" case.)
Thank you,
Edward

Edward was responding to an article I had written about how to evaluate 401k loans. Let me first compliment him on his generosity and willingness to help his nephew. But, if we step back and look at the situation we might find Mr. Neuman's handiwork.

Let's begin with the facts that Edward includes in his email. His nephew is 51 and got in enough credit card debt to declare bankruptcy. We don't know whether it was a job loss or medical issue that caused the credit card debt. But, it could be possible that Nephew is a little too quick to pull out the plastic when he sees something he wants. Edward needs to make sure that's not the case. If that is what caused the problem Nephew will probably not be able to keep the house even with his uncle's help. Sooner or later the credit card bills will begin to conflict with the mortgage. And some of the bills just won't get paid.

Ed is right. Finding a good deal on a mortgage will be hard. That's because lenders know that people who have had debt problems before are more likely than average to have them again. And, yes, a larger down payment will tend to keep the interest rate down But, look at where that down payment comes from. $29,000 comes from an interest free loan from Uncle Ed. (for the record, most mortgage loan agreements require you to disclose if you've borrowed or been given any part of the down payment. It could be illegal to fail to disclose the interest free loan)

The other portion would come from borrowing money from Newphew and his wife's 401k plans. Ed is concerned with the amount of interest that his nephew could save through the lower rate available in his 401k plan. Normally, I'd encourage that type of thinking. But, there are a couple of risks in using a 401k loan that could be much bigger than saving some interest.

Most 401k loans require a fairly short payback period. Nothing like the 20 or 30 years for most mortgages. So if you combine the mortgage payment and 401k loan payment, the earliest years of the mortgage will have the highest payments. That could be a problem.

Also, many 401k loans require that you pay them back completely if you leave your job. Even if it's not your choice to leave your job (read lay off or fired). That would put Nephew in a real bind. No income and a need to pay back up to $31,000 right now. Unless he has some other assets available (unlikely), he'll probably try to take a second mortgage against the house to repay the 401k loan. Finding a 2nd mortgage on his home could prove difficult. If not impossible. The only other options? Go to Uncle Ed for a second loan or let the 401k loan default. I have no way of knowing how a second Uncle Ed loan would work out. But, failure to repay the 401k loan means paying a penalty and income taxes on the unpaid balance of the loan. All of it. And, it also means that a bunch of Nephew's retirement money is gone forever.

So maybe buying this house isn't such a good idea. There might be a better option. Rent for a few years. Soon they'll be through repaying debt. Once that happens they can take the money that had been going to debt and begin saving up a down payment for the home. In a few years their credit score will improve. That will lower the interest rate on their mortgage (which will save them even more money). And, they'll also have some time to consider what they really need in a home. $300,000 buys a lot of house in most parts of the country. Something a little more modest might be in order.

Is it possible for Nephew to borrow money from his uncle, his 401k, buy this house and live happily ever after? Of course! But, with sub-prime mortgages defaulting all over the place you'd have to be Alfred E. Neuman to say "What, me worry?"

Keep on stretching those dollars!

Gary

The Dollar Stretcher : 401k loans

The 401k Layoff Trap

What? Me Worry?