Think twice before 401(k) borrowing

Q. I know you've written about the perils of borrowing from your 401(k) and have advised against doing so, but it was the only way to pay for our son's college. We could have told him to get loans, but we didn't want him to graduate with a large amount of debt. Now he has his debt-free college degree, is working in a fast-food restaurant for minimum wage and living at home while sending out resumes and networking. The company I work for is preparing to have a massive reduction in force for corporate types like myself. My outstanding loan from my 401(k) totals $43,500. I understand that they will withhold income tax on this amount if I am let go, but someone told me I'd also pay a 10 percent early distribution penalty since I'm only 56 years old. That doesn't seem fair, and I don't have an extra $4,350 lying around. Will there be a penalty in addition to the tax they will withhold?

I'm glad to hear your son is working while trying to find a career position; some college graduates seem to think they are above working for minimum wage. Perhaps he will determine that a management position in the fast-food industry is of interest. Your story is a good lesson for others. It is preferable for a young person to graduate with college loan debt than for a parent to deplete retirement assets. A college graduate has many options and years to repay student loans, while you have a limited number of options and time to repay your loan from your retirement plan.

If you leave the company for any reason, you will usually have 60 days to repay the loan. After 60 days, it is considered a distribution and is subject to state and federal income tax. The amount is also subject to a 10 percent early withdrawal penalty if you are under age 591/2 unless you meet one of the exceptions. The exceptions can be found in the instructions for IRS form 5329, and one would apply to you if you are part of the reduction in force or leave the company for any reason. Exception 01 reads: "Qualified plan distributions (does not apply to IRAs) you receive after separation from service in or after the year in which you reach age 55 (age 50 for qualified public safety employees)." So, at your age, you should not be subject to the 10 percent early withdrawal penalty.

Companies usually withhold 20 percent for income tax on distributions; this may not be sufficient. You may need to be prepared to pay higher federal and state income taxes when you file for the year of the distribution. An additional $43,500 added to your income could easily push you into a higher income tax bracket.

In addition to the risk of the accelerated payback of a 401(k) loan if you leave, the other disadvantages to borrowing from a 401(k) are lost investment opportunities and a negative tax impact. While the money is out of the account, any opportunity for investment growth is lost. Of course, in this market you aren't losing money either! When you pay back your loan, you do so with after-tax money. The $100 used to pay back your loan has been taxed, and when you make withdrawals in retirement, it is taxed again. Before borrowing from a 401(k), the major advantages of no credit checks and paying interest to yourself rather than a financial institution need to be weighed against the disadvantages.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question.