New data from Charles Schwab suggests parents may be tapping into their 401(k) retirement savings to pay for college. The financial services giant found requests for 401(k) loans jump about 16 percent on average during the June through August period.
While Schwab doesn't survey participants on why they take 401(k) loans, "some participants volunteer their reasons during the loan process," noted Catherine Golladay, vice president, participant services, in an email. "Reasons we most often hear cited are tuition, financial emergencies, and home purchase down payments."
Retirement plan loans typically must be repaid within five years, with the exception of a loan for a home purchase, which is usually a 15-year term. But if a borrower can't pay the loan back, it is considered a withdrawal from the plan -- triggering penalties and taxes. "We do not have specific data," Golladay noted, but "it is quite common for individuals who leave their company with an outstanding loan to take the loan as a distribution."
For example, Schwab has seen borrowers fall behind on their mortgages and take a 401(k) loan to catch up: "They really only forestall foreclosure by a couple of months since they have no longer-term plan or means to avoid foreclosure. In essence they have just kicked the can down the road, and have depleted their 401(k) without changing their situation."
Here are four reasons not to borrow from your 401(k):
While people pay back their loans, they usually stop contributing to their retirement plans. They lose the power of compounding over time that is key to making savings grow.
Loans are paid back into a 401(k) with after-tax money, which ends up getting taxed again when it's withdrawn at retirement. Here's an example: Someone borrows $2,000 from their 401(k). Let's assume their combined state and local income tax rate is 25%. Since the original contribution went into the plan pre-tax, their take home pay was only reduced by $1,500 to contribute that $2,000 into the plan. They will have to repay that loan with after-tax dollars ($2,000 in take home pay.) When they retire, they will have to pay tax on the withdrawal at ordinary income tax rates. So, they paid tax to put money back into the plan to repay their loan, and they will pay tax on that same money when they withdraw it at retirement.
If you leave your job for any reason while you're paying back the loan, the full amount is due very quickly, sometimes as soon as 30 days.
Money in a 401(k) plan is safe from creditors. Once you take it out of the plan, creditors can get at it.