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?