Tanisha A. Sykes

Special to USA TODAY

Corrections & Clarifications: Updates the story to clarify the reason for the Patricks' higher tax bill, why someone who borrowed from their 401(k) could lose a company match and additional 401(k) contributions and how loans from a 401(k) are funded. This version also clarifies an exception to the 10% penalty, how interest on a 401(k) loan is taxed, and the federal and state tax implications on a 401(k) withdrawal.

The 401(k) is considered the cornerstone of retirement, but when times get tough, some people treat it like a piggy bank.

Nearly 3 in 10 Americans dip into their retirement savings, according to Transamerica. The most common reasons include paying for higher education, dumping debt and footing the bill for unplanned medical expenses.

After all, life happens. That was the case for one married couple.

In 2013, Ashley and Tyler Patrick of Charlotte, North Carolina, were pregnant with a second child, but their small, two-bedroom brick ranch-style home required a remodel.

“We needed to connect a separate in-law suite to the main house to make room for our newborn before her birth,” says Ashley, 34, a financial coach who runs budgetsmadeeasy.com. Her husband, Tyler, 35, who works on an assembly line putting together different types of equipment, agrees.

To pay for the home improvements, the Patricks took out a $25,000 loan from Tyler’s 401(k) account. “It was a cheap way to borrow money,” says Ashley. “We had just purchased the house, so there was no real equity for the remodel.”

Equifax breach:Mistakes on your credit report could cost you thousands: How to fix them

Grumpy star:Grumpy Cat lives forever on the internet. These were some of her best memes

The funds reached their checking account quickly. Yet, it was a high price to pay. “We were hit with a $6,500 tax bill,” says Ashley.

The couple was hit with the bill because Tyler was laid off while he was still paying back the loan.

When you leave a company (whether voluntary or not), if the loan is not repaid, the remaining amount is treated as a taxable distribution, which means you will pay income tax. Plus, if you are younger than 55 or not in a year when you're turning 55, the outstanding balance is subject to a 10% early withdrawal penalty.

Most financial advisers tell clients to steer clear from taking money from your nest egg. If you decide to borrow from your 401(k), consider the pros and cons.

The pros

The process:

It’s often quick and less intensive than obtaining other types of credit.

“There’s no need for a credit check, underwriting, or lengthy application,” says Lauren Anastasio, CFP at SoFi, a personal finance company.

For Robert Barker, 43, a machinist in Shelby Township, Michigan, the process was simple. He took a loan from his 401(k) in November 2016 to cover $3,500 in closing costs on a condo purchase.

“I was surprised how versatile and easy it was to take the loan out of my 401(k),” says Barker. “I even changed the term of the loan to make the payment more affordable.”

Barker spoke to a representative from his company to walk him through the process. Before making this type of commitment, talk to a financial professional to understand the specifics of the loan.

Since you are borrowing from your investments, the interest rate for a 401(k) loan can be much cheaper than a traditional unsecured loan, says Anastasio.

The repayment terms:

Generally, you have up to five years to repay a 401(K) loan.

“However, for many plans, if the money is used to buy a home, the five-year repayment requirement is waived,” says Rob Drury, executive director, Association of Christian Financial Advisors in San Antonio.

Besides, payments are automatically deducted from your paycheck, which helps avoid the potential for late or forgotten payments, adds Anastasio.



The cons

The harsh repayment rule

If you leave your job, the outstanding balance of your loan has to typically be repaid in 60 or 90 days, says Robert Farrington, creator of The College Investor, which gives personal finance advice. The loan will be considered a distribution (aka income), and you pay taxes and a penalty on it, says Farrington. Per the IRS, "you may also have to pay an additional 10% tax on the amount of the taxable distribution, unless you are at least age 59½ or qualify for another exception." One exception is this: If you’re separated from your job when you’re 55 or older, or in the year you reach 55, you won’t pay the 10% additional tax on a loan that becomes a distribution.

Here’s a loophole from the Tax Cuts and Jobs Act: If you left your job in 2019, you don’t have to pay taxes or the penalty if you repay the loan in full or roll it over to another plan by April 15, 2020 (or Oct. 15, 2020, if you file an extension). In other words, the loan has to be paid in the same tax year in which you left your job. Check with your accountant to see if you can take advantage of this loophole.

Here’s another consideration if you want to tap your 401(k) for money: According to IRS regulations, there is a 10% penalty if you withdraw funds — rather than take a loan – from your 401(K) before the age of 59½. Also, your plan provider has to withhold 20% for federal income taxes and, where applicable, a percentage for state income taxes, if you withdraw the funds instead of taking a loan.

The tax consequences:

Before you borrow a cent, understand the tax implications of taking a loan from your 401(k) plan.

When you pay back the loan, the interest portion of your payment is essentially taxed twice.

“The interest … is money that didn’t originate from the plan and is paid with after-tax dollars,” into the 401(k) account, says Kyle Whipple, a financial adviser for the C. Curtis Financial Group, in Plymouth, Michigan. “Therefore, you will be taxed again on those funds when you withdraw them from your plan in retirement.”

The lost gains:

When borrowing from a 401(k), there is a big opportunity cost. Borrowers miss the compound growth that their investments would have earned in the market. Also, some plan participants stop contributing to their 401(k) plan or reduce their contributions while repaying the loan. Therefore, they reduce or don't get the company match.

“You lose time and money on the growth of the borrowed amount, the loan payments are taking the place of previous contributions, meaning you lose the company match and your additions, and you lose money to the fees associated with the loan,” says Whipple.

To minimize the hit to your long-term savings, keep contributing to your 401(k), if possible, so you can continue to receive any employer match, he says.

While taking a loan from your 401(k) isn’t ideal, it’s essential to understand the complete picture before deciding.