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Borrowing from 401(k) Risky Debt-Relief Tactic

In these difficult economic times, more and more people are feeling overwhelmed by credit card debt, medical bills and other expenses. As the economy continues to limp along, people in need of extra cash because of burdensome consumer debt are borrowing from their 401(k) accounts or other similar retirement savings accounts. Taking such a loan is a risky financial move, however, and may end up putting the borrower in a much more precarious financial position than he or she was prior to the loan.

Statistics show that 401(k) borrowing is on the rise. According to research the Employee Benefit Research Institute (EBRI) conducted, of 20 million 401(k) participants across the country, 21 percent had taken out loans from their accounts by the end of 2009 - an increase from 18 percent for the previous three years. This was the highest number the EBRI recorded since it began collecting data on this topic in 1996. The Vanguard Group reported similar numbers among the plans the company administers: 18 percent of participants had loans from their 401(k) accounts at the end of 2010, up from 16 percent for the past three years.

Many who take out such loans do so in the face of crushing bills, having few other options for credit. In the poor economy, banks are less willing to lend money and the declining housing market means that people have less equity in their homes against which they can borrow. People believe that they can repay the loan after they pay off their bills.

However, many do not understand the risk associated with such a move. Often, if an employee loses his or her job, a 401(k) loan becomes due within 60 days or the unpaid balance of the loan counts as a withdrawal from the account - meaning the employee will owe taxes on that amount, as well as a 10 percent penalty for withdrawing money from the account before retirement age. Individuals are then left with needing to cash out the rest of the account in order to pay taxes and penalties - along with more taxes and penalties for cashing out the rest of the account - and no longer have any retirement savings.

Even if an employee does pay the loan back in full, he or she still loses financial ground. An employee is not able to contribute any money to the 401(k) while making payments on the loan, meaning that the employee's retirement savings is not growing during that payment period, which can last up to five years.

Financial advisors caution people to think very carefully before taking out a 401(k) loan and to weigh the risks. People should explore all other options for credit before turning to a 401(k) loan. If no credit is available, financial advisors also suggest that filing bankruptcy might be the solution for those under particularly crushing consumer debt loads. For those in such a situation, a loan from a 401(k) would merely stave off filing bankruptcy for a brief time, with the added drawback of depleting retirement savings. Filing bankruptcy has the benefit of protecting the retirement assets that the filer has already amassed at the time of filing.

Many people are struggling as the nation's economy shows few signs of improvement and are looking for ways to help them pay their bills. While taking a 401(k) loan is becoming a more popular option as a solution to the problem of needing credit, the risks associated with such a move should make people cautious about taking such a step.

Source: Workers Increasingly Raid 401(k)s for Short-Term Cash

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