A caller to the Suze Orman show (”You Can Roth” episode aired on 01/26/08) wanted to tap her 401(k) retirement fund to pay off about $20,000 in credit card debt.  The caller told Suze that she was contributing 6 percent of her salary into the 401(k) account with a match of 3 percent from her employer and explained that she would pay back into her 401(k) account the amount she borrowed plus 9.5 percent interest within five years.  The question piqued my interest because I have a friend who is thinking of quitting his job and starting a business.  He wants to withdraw funds from his 401(k) retirement fund to pay for his family’s expenses while he works to get the business off the ground.  My gut feeling about my friend’s plan: doesn’t sound like a good idea.  My reaction mirrored Suze’s response to the caller, which was no way!!  Why?  Suze explains:

• Even though the caller would be paying 9.5 percent interest to herself, she is paying the loan back with after-tax dollars.  Once she reachs 59 1/2 years of age, and can withdraw the funds, she will pay taxes once again on that money, effectively subjecting the amount of the loan to double taxation.
• If the caller is laid off or quits her job, most 401(k) plans require immediate repayment.  If she can’t pay it back, she would owe ordinary income taxes and a 10 percent early withdrawal penalty.  Ouch!

Suze offered the following advice, which I thought was very prudent.  Lower the amount of her contribution to her 401(k) to 3 percent, the same percentage matched by the employer, and use the excess cash in her paycheck towards paying off her credit card debt.  Why put money into the 401(k) only to take it out again in the form of a loan? 

Suze also pointed out that money taken out of your 401(k) will not enjoy compounding returns and growth in the stock market.  Additionally, although Suze didn’t mention this, now may be a very bad time to borrow funds from the 401(k) account because of the severe drop in the stock market over the past few weeks.  You may be liquidating your 401(k) mutual funds and stocks at a price significantly lower than the price you paid for them, depriving yourself of the opportunity to recover your paper losses in the market.  Now, my friend is planning to quit his job and then borrow funds from his 401(k) account, which presumably will be rolled over into a traditional IRA when he leaves his company.  The more prudent move to make would be to reduce his contributions to his 401(k) acccount and put as much cash as he can into a savings account/rainy day fund.  He should use that fund for his living expenses, not the 401(k).  It’s already a bold (and admirable) move for my friend to quit the steady day job and plunge into the entrepreneurial world.  Why risk going deeper into the financial hole by raiding the 401(k) account, especially when you don’t need to?