Net Gains: Why You Shouldn't Take a 401(k) Loan

Amid the subprime loan crisis, a housing-market collapse and talk of recession, there are signs these are perilous times for retirement savings. The Associated Press last week reported big 401(k) providers like Fidelity Investments are seeing increases in loan requests and hardship withdrawals as workers look for a financial lifeline.

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I'm worried the situation will only get worse.

For the unfamiliar, let's review the rules surrounding 401(k) withdrawals and loans.

Generally, money deducted from your paycheck on a pretax basis and deposited into a 401(k) account is not to be touched until at least age 59½ at the earliest. Tax law allows for hardship withdrawals, but the standards used by the IRS make it tough to qualify.

In most cases, an outright early withdrawal from a 401(k) will result in a 10 percent penalty plus ordinary income tax on the amount withdrawn. That means on a $10,000 withdrawal you could lose $4,000 in taxes and penalties if you are in the 25 percent tax bracket and live in a state with a 5 percent income tax.

The easiest way around the 10 percent penalty plus the ordinary income tax is to obtain a loan from your 401(k) account through your employer. Typically, employers allow 401(k) loans as a means of encouraging employees to participate in the plan. The thinking is that allowing workers limited access to retirement savings will encourage greater participation and higher contribution levels.

The problem is even the less-onerous loan provision still exacts a financial toll.

There are at least three ways a worker loses out when taking a 401(k) loan:

Lost investment earnings: When you remove money from a 401(k) account, you take away its potential to earn tax-deferred investment returns and grow through the power of compounding. Yes, you are paying interest on the loan, but the interest rate on the loan is often lower than the return you can earn on a well-diversified portfolio of stock and bond mutual funds.

In my case, the lost compounding potential came at a particularly high cost because at the time of the loan my wife and I were more than 35 years from retirement. That's the major source of the lost $18,000 in retirement savings I mentioned above.