Cracking Into Your Nest Egg Early
Most people who diligently tuck money into a 401(k) know that those dollars are intended for retirement. But many 401(k)'s have provisions that allow workers to take loans when necessary. And economically squeezed workers are increasingly raiding their retirement plans to make ends meet.
Here's how 401(k) loans work. If your 401(k) plan allows loans, you can borrow $50,000 or one half of the vested balance from your retirement account, whichever is lower. Any loan has to be repaid within five years, except for loans taken out by first-time homeowners who get up to 15 years to repay.
If you don't make payments, the outstanding loan amount is considered a taxable distribution from the 401(k), and if you're younger than 591/2, you'll also get hit with a 10 percent penalty. "If you miss a loan payment, you hurt your credit rating. If you miss a payment on a 401(k) loan, it is considered to be in default," warns Michael Kresh, a certified financial planner in Islandia, N.Y. "Under many plans, a defaulted loan is considered a taxable distribution, and it will immediately trigger an income tax on the total amount of the loan." (My Money Blog has an interesting discussion going about how 401(k) loan repayment can affect taxes.)
The average loan amount grew by 61 percent from $4,912 in 1995 to $7,932 in 2004, according to a recent report by the Center for American Progress think tank. While 401(k) loans help workers in the short term, many workers don't save—or save less—during repayment than they otherwise would have. And that hurts retirement security for the future. A worker who takes a fairly modest loan of $5,000 in 2008 dollars and makes only loan payments during repayment reduces his total retirement savings between 13 and 22 percent, CAP calculated.
It also helps if a worker can continue to make regular contributions to the 401(k) while repaying the loan. But for the workers who take out loans because of a spell of unemployment, bad health, or to purchase a home, it may be unrealistic to think that families can make their original contributions while also repaying the loan, Christian Weller and Jeffrey Wenger, the authors of the CAP report, write.
The Pension Rights Center in Washington, D.C., is advocating a zero tolerance for preretirement access to 401(k) accounts. "While this might mean that some employees would not contribute quite as much to their 401(k) plans, it would also mean that what they did contribute would be there for retirement," the center says in a statement for the U.S. Senate Special Committee on Aging, which held a hearing on reducing 401(k) losses caused by loans and withdrawals last week.
Tell us, would you contribute to a 401(k) knowing you could not get the money for any reason until retirement?
Tags: personal finance | retirement | 401(k)
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Reader Comments
Loans
I agree that for most, the use of a 401(k) for a piggy bank is not a good idea and not what the intent was. The flip side of this is that loan interest rates are usually 2% over prime. Is it better to have $5k out on a credit card with a 19% interest rate or a prime +2%? I would argue for the 401(k) loan.
If you have a DB Retirement Plan already or some other kind of annuity, the 401(k) may be a great place to stock money away for college and then take a loan. Over a 10 year stretch, stocks return 9-11%, right? What do 529's return? Not nearly as high would be my guesss (might be an interesting article).
While it's true that failure to repay a 401(k) loan can hurt your credit, 401(k) loan repayments are done through payroll deduction. You can not just "stop" them from happening without going through payroll and telling them that you are going to default.
Hardship withdrawals are a different story and unfortunately, I've been seeing a steady increase over the last few years. This is not surprising given the housing crisis.
To answer your question, that is currently an option. If you run a 401(k), you do NOT have to have a loan policy. That is the choice of the administrator. Nobody want's that though because there are emergency situations. You gotta be able to eat and have roof over your head.
The maximum term is not 15 years
It's true that a common example given for residential loans is 15 years, but The ERISA Outline Guide, recent loan policies I've seen, and my understanding of the regs is that "any reasonable period" can be used; Tripodi specifically references 30 years. There have been a spate of news stories all saying 15 years, but this just doesn't appear to be supported.
I agree that there are costs to 401(k) loans, most particularly if the participant discontinues regular contributions in favor of repayment. I just wanted to correct at least one of the "facts" I see reproduced in the popular press, whcih almost always gets it wrong on retirement plans.
401(k) Loans
One of the pieces of important information that appear to be left out in so many of the aritcles I've read regarding the problem in taking 401(k) loans is that assuming the employee makes regular payments, the employee is ulimately paying taxes twice on that loan money:
First, when repaying the loan and interest because the repayments are made with after-tax money, and
Second, when the employee does take a distribution from the plan at retirement (or termination).
Since the advantage of 401(k) plans is that employees can defer paying taxes until the money is distributed, it has always seemed to me that taking a loan and then having to repay that loan with after-tax dollars is defeating the purpose of a tax-deferred retirement plan.
Just a thought...
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