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Borrowing Trouble
By Karen Hube, January & February 2005
She took a big 401(k) loan. Is she now trapped in her current job until she can repay the debt?
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Carey Bahl, 53, is trying to decide whether to leave her secretarial job for
a position at another firm that would pay her $3,000 more a year and cut her
hour-long commute in half. That's a no-brainer, right? Not so fast. Carey
recently borrowed $25,000 from her 401(k). She used $5,000 to help pay for her
father's funeral, $14,000 to pay off credit card debt, $4,000 as a down
payment on a new car, and $2,000 to take a Caribbean vacation with her
daughter.
The Problem
Carey, like many others who have raided their 401(k)s, is finding out that
she's trapped by the loan. If she resigns from her current job, she'll
have to repay the money in full by her last day of work or the money will be
considered a withdrawal. If that happens, she'll owe income taxes on the
$25,000, plus a 10 percent early-withdrawal penalty.
The Plan
Carey, forgive me, but what were you thinking? A 401(k) loan for funeral
expenses makes sense on compassionate grounds. But for credit card debt? A new
car? Time in the sun? "The last thing you want to do is use future
retirement money for current consumption," says Eleanor Blayney, a
certified financial planner in McLean, Virginia. That's not only because
you potentially lose years of retirement savings but because you have to pay
yourself back with after-tax dollars.
Obviously, the best debt is no debt. But now that you've already
borrowed from your 401(k), you must pay back the loan within five years or face
taxes and penalties. With interest—rates on 401(k) loans are typically 1
to 2 percent above prime—your minimum payment will be about $480 a
month.
Your dilemma right now, though, is that you want to switch jobs. If you had
a home, you could take out a tax-deductible home-equity loan to pay off the
401(k) loan, then make a schedule to repay the home-equity loan as soon as
possible. Unfortunately, you rent your condo, so a home-equity loan isn't
an option, and your credit history would make it difficult to get a bank
loan.
So you're right, you're stuck in your old job for now because you
have no way of repaying your 401(k) loan. "It makes no sense to incur
taxes and penalties—they would amount to about $7,500," Blayney
says. Even with your $3,000 raise, which translates into about $2,400 after
taxes, you'd spend more than three years at your new job making up the
difference.
Your best choice? Thanks to a little-known tax rule, staying on the job for
another couple of years makes a lot of sense. That's because if you are 55
years old at the end of the year in which you leave your job, withdrawals are
not subject to the 10 percent penalty. You will have paid down about $10,000 of
the loan by then, and while you will still owe $3,000 in taxes on the
loan's outstanding $15,000, at least you won't owe any penalties. The
risk is that you may not find a better-paying job once you're ready to look
for one. But you will have learned a valuable lesson about the importance of
saving.
Karen Hube has written for Money magazine and The Wall Street
Journal.
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