For Americans just scraping by, the only savings they've salted away are in a 401(k). That was fine in a growing economy. But now that it's slumping, inflation is up and layoffs are spreading, a small but increasing number of people are tapping those accounts. T. Rowe Price says 401(k) withdrawals rose 19 percent last year through June 2008. Vanguard reports its hardship 401(k) withdrawals rose 22% in 2007. Though just representing 1.5% of all plan holders–these numbers are nonetheless troubling. Moreover, withdrawals aren't the only threat to the 401(k) assets of 44 million American workers.
Since 2003, many plans have been offering debit cards, making it easy–though not necessarily wise–to borrow up to one-half of 401(k) plan assets or $50,000, whichever is less. Borrowing is not considered a withdrawal, which means for those under 59 1/2, no tax and no 10% IRS penalty. That is, unless the borrower misses three monthly payments on the loan or leaves the company before paying it off, making it a premature withdrawal.
However, while the money is borrowed, it earns no interest in the 401(k). This makes for an expensive opportunity cost. The Center for American Progress (CAP) says a five-year, $5,000 loan at 7.3%, taken out five years into a 401(k) program, assuming only loan repayments during the payoff period, could result over 35 years in a 22% loss in retirement income (assuming an average annual investment return of 9.2%). CAP says 5.4 percent of plan holders took hardship withdrawals over this past year. Workers borrowed a total of $31 billion from their 401(k) plans in 2004, according to a CAP study.
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Although the total number of 401(k) borrowers remains small, it's "higher in parts of the country where incomes have been hit hard," says David Ray, an analyst with the Profit-Sharing Council of America (PSCA). Worried that workers may reach retirement with depleted savings because of borrowing, Sen. Herb Kohl (D-Wis.), chair of the Senate Special Committee on Aging, held hearings on a bill (S. 3278) that would restrict such borrowing. But PSCA's Ray cautions that trapping funds in 401(k) plans could backfire. "If people think the money is going to be locked away in an emergency they may not invest in a plan," he says. "When I was in a company running the benefits program, the loan option was a big selling point for getting young workers to sign up." Kohl's bill won't likely move forward until next year.
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