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.
After-tax payments: Borrowing from a 401(k) strips away its tax advantages. Each dollar you remove had been contributed on a pretax basis, meaning you did not pay an income tax on that dollar when you first received it from your employer.
But when it comes to paying back the 401(k) loan, you are using dollars already taxed by the government. To pay back one dollar borrowed, you many need to earn $1.18 or more, depending on your tax bracket and what state you live in.
Lower contributions: Those carrying the burden of 401(k) loan repayments are likely to make lower contributions to retirement savings than they otherwise would. Even if they do not lower what they had been contributing, increased contributions are less likely.
The greatest danger may be inability to repay the loan. If you lose your job or change jobs voluntarily, the employer may require immediate repayment on the outstanding loan balance. If you default on the loan, you will be hit with the 10 percent penalty and ordinary income tax mentioned above.
For these reasons and the sake of your future retirement, consider a 401(k) loan only as an absolute last resort, not as a quick fix to short-term cash crunch. Don't make the same mistake I did.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at firstname.lastname@example.org