Taking Care of Mom and Dad: Borrowing from a 401(k) Plan

Many plans allow workers to borrow money against the funds in their accounts. If your parents have done this, they've essentially borrowed the money from themselves. The interest that they pay to the plan for the loan is just like any other earnings of the plan -- it's tax-free. So, in some cases, plan administrators encourage the loans.

For a younger person, borrowing against 401(k) funds can be a good idea; but it doesn't make so much sense for older employees. They're more likely to need access to the money sooner. And they certainly need to be earning interest instead of paying it.

Unfortunately, some older people borrow against their retirement money...and haven't paid the loans back if they are forced to retire earlier than they had expected.

Loans against retirement funds are usually limited by the government to the lesser of $50,000 or 50 percent of the account balance. So, even if your parents have borrowed, there should be some funds available to them.

If your parents quit, are fired or are forced (by their health or other factors) to retire early, 401(k) loans usually have to be paid back right away. If your parents don't have enough money to pay the loan back, the loan will be treated as if it were a regular distribution. Your parents will have to pay taxes at their marginal tax rate on the amount of the loan and -- unless they're over 59½ -- a penalty equal to 10 percent.

Why the penalty? A 401(k) plan is intended to fund your parents' retirement, so they're not supposed to start taking out money until they are 59½ years old, they're seriously ill or they retire due to a permanent disability. Another problem with early distributions: The plan administrator may withhold an amount equal to 20 percent of the distribution for taxes.

The real advantage of a 401(k) is as a long-term investment. The benefits are difficult to beat and the ability to contribute pre-tax funds can really supercharge your parents' retirement savings. These benefits make up for the restrictions otherwise placed on the investment.