401k Layoff Trap
By Gary Foreman
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
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
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
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
- 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
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 Foreman is the editor of The Dollar Stretcher.com <
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