cash strapped americans raiding their 401k's

Cash-strapped Americans raiding their 401(k)s

By Jilian Mincer | Dow Jones Newswires
October 14, 2007


Despite potential tax and investment problems, more investors have been borrowing from their 401(k) plans or taking hardship withdrawals in recent months, some retirement plan providers say.

Many in the field expect more borrowing in 2008, as consumers struggle with tighter credit and potentially higher mortgage payments.

"I don't think it's a groundswell but it's enough to be noticed," said Rick Meigs, president of 401khelpcenter.com, which provides information on 401(k) plans.

Increased borrowing on 401(k)s could be because of the credit crunch and slumping housing prices. To be sure, the indications are preliminary; it's too early to say why it's happening, according to the Hartford Financial Services Group.

Borrowing against your retirement nest egg may seem tempting but it presents a host of problems. It could significantly reduce your savings at retirement and create an expensive tax bill if you can't repay the loan when it's due.

Almost all plans allow borrowers to take money out of their 401(k) accounts and repay it plus interest, which is typically 1 or 2 percentage points above prime. Although plans vary, the most you can borrow typically is the lesser of 50 percent of a vested balance or $50,000.

Employees usually must repay money borrowed for a mortgage within 15 years, and money used for other purposes within five years. Most loans also have a $50 to $100 fee.

If you fail to pay back the loan on time and are younger than 59 1/2, you are subject to regular income tax and a penalty tax of 10 percent for early withdrawal.

"A few years ago, the buzz was about borrowing from a 401(k) to buy a second home," said Jeff Carbone, a financial adviser in Cornelius, N.C. "Now it's people looking at their 401(k) because they've extended themselves on their homes and credit lines."

Even though his clients typically have investable assets of at least $750,000, Carbone said some have "maxed out their credit" and feel the pain of higher payments for a home-equity line of credit.

Pamela Hess, director of retirement research at Hewitt Associates, sees "a marginal uptick" in borrowing. "The economy isn't as strong as it was a couple of years ago," she said.

Indicative of some of the stress, the amount of calls to Principal Financial Group Inc. about hardship withdrawals, while small, has jumped significantly in recent months, company officials said. Not all 401(k) plans permit hardship withdrawals, but the IRS allows them for, among other things, medical or funeral expenses, purchasing a primary residence, or avoiding eviction from or foreclosure on a primary residence.

The number of calls asking about withdrawals to prevent a potential foreclosure or eviction doubled in August over July, said Janet Fossell, director of individual investor services for Principal. There were fewer calls in September than August, but still more than in July.

"I think a lot of individuals are looking for different options," she said. "This is really a last resort."

Jamie Cornell, senior vice president, employer marketing at Fidelity Investments, which hasn't seen a loan increase, said: "This should be the lending source of last resort."

About 20 percent of Fidelity 401(k) investors have a loan, a figure in line with the industry.

Loans on 401(k)s are popular, said Bill Arnone, a partner at Ernst & Young, because there's no credit check, making them easy to obtain.

Even a person who pays such a loan back on time, and therefore avoids the 10 percent penalty, is getting taxed twice, Arnone said -- once when repaying the loan with after-tax dollars, and a second time when the money is withdrawn at retirement.

People who take the loans also lose out on potential retirement earnings while the money isn't invested.

T. Rowe Price has calculated that someone with a balance of $150,000 who borrows $10,000 at age 40 would see an $83,137 difference at 65 even if the loan is repaid, given an 8 percent return on investments and a 7 percent interest rate on the loan.

Should you lose your job, the costs could be even higher.

"The biggest reason [not to borrow] is the consequence if there's a separation from your employer," said Stuart Ritter, a financial adviser for T. Rowe Price.

Borrowers who are fired, laid off or quit typically have to pay off the loan within 90 days, Ritter said. If they don't and are younger than 59 1/2, they face income tax and penalties.

And the income could throw you into a higher tax bracket, said Linda Leitz, a financial adviser in Colorado Springs.

"What I'm finding is Americans in general are spending more than they make," Leitz said.

"And as the mortgage industry implodes, they look for where else they can borrow."

David Wray, president of the Profit Sharing/401(k) Council of America, a non-profit association of companies that sponsor plans, expects that higher payments on adjustable mortgages will have people "looking for ways to make up that gap."

He warns people not to use their 401(k) savings if they're going to end up in bankruptcy. That's because in most plans, the 401(k) assets are protected in bankruptcy.

"The real issue is, what are people facing foreclosure going to do?" he said. "You don't want to tap the plan just to buy time because then you lose your home and your retirement."