Borrowing From Retirement Plans Surges

As Shakespeare said, never a "lender, nor a borrower, be." He could have been talking about 401(k) plans.

Over the years, loans drawn against 401(k) plans have proven popular. In 2004, they accounted for $6 billion, and by 2006, the tally had risen to $49 billion, according to an estimate by the Employee Benefit Research Institute in Washington D.C.

The Transamerica Center for Retirement Studies, a nonprofit funded by Aegon's(AEG Quote) Transamerica Life Insurance, purports that participants holding a 401(k) loan jumped from 11% in 2006 to 18% in 2007. Some plans have gone as far as selling debit cards directly linked to 401(k) accounts, offering an automatic loan rather than a typical withdrawal as if one were using a MasterCard (MA Quote) or Visa(V Quote).

Although the rules that apply to Individual Retirement Account plans are more varied and less restrictive, IRAs may not offer loans. The anti-loan stance taken by the Internal Revenue Service regarding IRAs has even led to increased enforcement of rollovers. When moving funds from one IRA to another retirement plan, there's a 60-day deadline to complete the process. Failure to do so means getting socked with a 10% penalty and all applicable taxes. The reason for increased IRS scrutiny is that an increasing number of people were stretching out the time used to transfer the funds to offer themselves a short-term, interest-free loan.

A 401(k) loan has attractive features. The tax code allows for half the account balance to be borrowed, with a cap at $50,000. Because it's from your own savings, there's no bank or lender involved, no risk of denial and no need for collateral. Unlike a standard withdrawal of retirement funds, there's no 10% penalty or additional taxes.

Critics sound warnings that such loans should only be used as a last resort. In the event of a default, all taxes and penalties are fully assessed. In the case of a job loss, the full balance becomes due within 90 days, with failure to do so evolving the "loan" to a "withdrawal."

The warnings also point to a not-so-obvious cost: Any money withdrawn doesn't accrue interest, and repayment is made using after-tax dollars. That can amount to a 30% penalty.