Cracking Your Nest Egg If You Must

It's your money. You've been saving it for years, watching it grow into a tidy pile. Now, you need to get hold of a few thousand dollars to put a downpayment on a house. But it turns out your beautiful cash hoard is virtually off-limits.

They don't call them tax-qualified retirement plans for nothing. Invented by Uncle Sam in the 1970s to shift the financial burden of Americans' old age from government and companies to individuals, such plans offer generous tax incentives to put money aside for retirement. Your contributions reduce your taxable income, and every penny you earn on them is tax-exempt until you take distribution. The catch: Using the money for anything but retirement is subject to strict rules at best and stiff penalties at worst.

That's because the laws governing such plans, whether in the Internal Revenue Service code or the Employee Retirement Income Security Act (ERISA), were written to discourage you from raiding your nest egg. You can't even use tax-qualified accounts to secure a personal loan. "The big no-no is diminishing your retirement account," says Monica Thompson, a benefits consultant at Hewitt Associates.

LAST RESORT. There are ways to get around the restrictions when you're strapped for cash. But even when you can, you should think of most qualified plans as lenders of last resort. Tax-free compounding is such an effective route to future security that a small amount taken from the kitty today can make a huge difference in your balance at


Company-sponsored 401(k) plans have become the most popular qualified savings accounts for retirement. Typically, employees contribute through pretax payroll deductions, and employers match part or all of those contributions. You may invest your account in any of several funds, which usually include fixed-income, stock, and money-market funds. The funds are managed by an outside plan administrator.

To encourage employee participation in 401(k) plans, nearly 70% of companies offering them include loan provisions that make the accounts somewhat more liquid than other types of qualified accounts--even though there's no law requiring them to do so. "Sponsors stress the flexibility of borrowing provisions so employees don't feel like they're tying up their money for 40 years," says Michael Scarborough, president of the Scarborough Group in Annapolis, Md., a 401(k) consultant whose clients include General Motors and AT&T. And recent surveys show that 20% to 25% of participants borrow from their plans.

But while ERISA doesn't force companies to allow 401(k) loans, it sets parameters for those that do. You may borrow half your vested account balance, up to a maximum of $50,000. The law imposes no minimum, but few companies want the administrative hassle of lending amounts under $500. You must repay the loan at least quarterly, through payroll deductions, within five years--unless you have borrowed to buy a primary residence, in which case the term can stretch to 30 years. And the loan must be amortized: You cannot create a "balloon" loan by paying interest only and leaving the principal repayment until the end of the loan term. Companies must charge market interest rates, usually a point or two above prime. Your rate is normally fixed until the loan is repaid.

Borrowing from a 401(k) plan can be an attractive option. Nobody checks your credit history, and very few companies charge application fees. The interest is reasonable, you pay it to yourself, and your account balance

is your collateral. In most cases, you can even keep contributing to your plan--and receiving company-match money--while the loan is


Best of all, as long as you continue giving regularly to the plan, make all your loan payments on time, and the interest on the loan matches or exceeds the rate your account would have been earning anyway, there will be no opportunity cost. In other words, you will not lose any savings when the loan is paid off. "The only difference is if the loan interest rate is less than what your account is earning, you would be a little behind at the end," says Ethan Kra, managing director at William M. Mercer Inc., a benefits consulting firm.

Assuming that's not a problem, however, there's another reason not to jump automatically into a 401(k) loan. Unless you tap your aftertax

or matching account to make an investment or actually take out a mortgage, you cannot deduct your interest payments. And when you retire and receive that money, the IRS will get a cut. That's because the money you use to repay your loan, unlike 401(k) contributions, is aftertax dollars.

Where should you look instead? "If you can take out a home-equity loan," says Scarborough, "do that and write off the interest." After the tax deduction, a home-equity loan at 8% interest has a net cost of about 5%, Scarborough notes. "Obviously, your 401(k) plan is earning more than that." Similarly, investors who want to act on a hot tip would be better off paying their brokers margin interest, because that's also tax-deductible--and averages only 6%. Credit cards, with their nondeductible interest and double-digit interest rates, are clearly a poor choice.

BARBED WIRE. If your 401(k) doesn't have loan provisions, the consequences of raiding it are dire. Here, the rules are the same as for individual retirement accounts, Keoghs, and simplified employee pensions (SEPs), all of which are festooned with the IRS's version of barbed wire: Without loan allowances, your only alternative is early distribution, complete with federal and state taxes plus a 10% penalty if you're younger than 59 1/2.

Companies must require that you prove hardship before you can take early distribution from a 401(k). Under the most commonly used definition of hardship, you must show that you have exhausted all other borrowing possibilities, and you may use the distribution for only four reasons: to buy a primary residence, to pay for postsecondary education, to meet necessary medical expenses, or to forestall eviction from or foreclosure on your home. On top of having to pay income taxes and the penalty, you're barred from contributing to your account for a year. And if you take out a significant amount, the annual maximum you can contribute to qualified plans, currently $8,994, means you may never make up the difference.

The government doesn't care whether you prove hardship or not in assessing the 10% penalty. With 401(k)s, the penalty is waived only in cases of death, disability, termination of employment after age 55, medical expenses to the extent that they qualify under the IRS's deductible medical-expense rules, and distributions to a spouse under a divorce decree. For IRAs, even termination of employment, medical expenses, and divorce cases won't cut it. "Hardship distributions are a disaster," says Alan Nadel, a partner at Arthur Andersen in New York. "You're not supposed to think of these accounts as short-term savings plans."

Deft borrowers with IRAs may be able to take advantage of the rollover provision. You can take money out of an IRA with no taxes or penalty, provided that you replace the funds within 60 days. And people with large retirement-account balances who are desperate for regular income can take the equivalent of early retirement: They may start getting distributions at any age without the 10% penalty--if they receive substantially equal periodic payments. Essentially, that means you are turning your IRA into an annuity.

For sponsors of 401(k) plans, deciding whether to offer loan provisions is often difficult. Young people are legitimately fearful of locking up their money for decades and may avoid the plans if they can't borrow. But not joining a 401(k) plan is far worse than joining it and tapping it for a loan. Says Richard Pallan, chief of defined-contribution plans at Putnam Cos.: "You have to say, 'There's liquidity, but I don't really want you to use it.'" For savers, it's a matter of learning to think of qualified plans as the pot at the end of a long, long rainbow.