James O’Connor left his job as a TV producer in Washington, D.C., to move to northern California after his girlfriend, who works in the wine industry, was transferred to Napa Valley.
His plans to find another job in San Francisco did not work out as well as he hoped, and after several months of unemployment, he took $24,000 out of his 401(k).
It’s an all-too-familiar story these days as cash-strapped Americans turn in record numbers to their 401(k)s, an easily accessible source of financing but a route few really want to take.
“I wish I could go back in time and warn myself not to do it,” said O’Connor.
The problem – and its potential solutions – are getting more attention nowadays, with policymakers, lawmakers and others debating how best to address it.
Because he was unable to put the money back into his 401(k) account, O’Conner ended up paying 20 percent in income taxes on the withdrawal and was hit with the typical 10-percent penalty.
“You have to pay taxes and pay penalties, so up front you’re getting back less than what you put in, and then the double-whammy is you are damaging your long-term savings prospects, money that’s invested and expected to grow,” said Justin King, policy director of the Asset Building Program at the New America Foundation. “A lot of folks would have been better off putting the money into a savings account at a bank.”
People used to be able to refinance their homes or take out a second mortgage, but since the housing collapse of 2008, that’s just not a viable option.
“After the crash we saw credit standards raised and we saw people underwater on their mortgages, so they aren’t going to have access to home equity lines of credit, (and) so what’s left to them is the money they’ve been putting into retirement,” said King.
Of course, most participants in defined contribution plans are allowed to borrow from their 401(k) accounts, and nearly 40 percent do so over a five-year period, according to a working paper published by the Pension Research Council at the Wharton School, University of Pennsylvania.
Although participants are required by law to repay 401(k) loans plus interest on a set schedule, usually through deductions from their payroll, and 90 percent of borrowers do so, one in 10 does not return the money.
In “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” Olivia Mitchell, professor of Business Economics and Public Policy at the Wharton School, Timothy Lu of Peking University’s HSBC Business School, and Stephen Utkus and Jean Young of the Vanguard Center for Retirement Research, provide a new estimate of loan defaults. They believe that number is $6 billion annually, much higher than the Government Accounting Office estimate of $561 million.
Their research also found that an employer loan policy has a strong impact on 401(k) withdrawals. In plans allowing multiple loans, participants are more likely to borrow and take out larger loans. While employees with fewer assets were found to be most likely to borrow, those who are better-off take out larger loans.
By law, participants can borrow only half of their account balance with a maximum loan of $50,000. But plan sponsors can impose their own rules, including whether straight-up withdrawals (vs. loans) are permitted, the number of withdrawals or loans allowed, whether there is a minimum amount for either, and what amount of interest the borrower must repay.
Retirement experts and politicians who are concerned about early 401(k) withdrawals have wide-ranging views on what should be done to slow withdrawals and prevent loan defaults.
The authors of “Borrowing from the Future” suggest there could be greater restrictions placed on 401(k) loans. “Limiting the number of loans to a single loan would reduce the incidence of borrowing and the fraction of total wealth borrowed, thereby reducing the impact of future defaults,” they wrote.
“Another option might be to further limit the size and scope of loans, for instance allowing participants to borrow only a quarter of their account balances.”
Norman Stein, a professor at Drexel University School of Law who is an authority on employee benefits and tax law, says the most effective approach would be a mandatory, air-tight system in which “everyone participates in the plan, you have to put money in and you can’t take it out.”
He acknowledged, however, that may not be a popular solution and suggested as an alternative a hybrid plan. “Give employees a choice, give them an incentive to put money into the types of accounts where they can’t take the money out unless it is rolled over to other accounts where they are locked down,” he said.
That incentive could come in the form of a tax credit, a savers credit, or a matching credit from either the employer or the government for those in certain income brackets.
Stein said another possibility would be to provide access to some, rather than all, of an employee’s savings. “After so many years you could access your contributions but not investment income or any employer or government matching credit. You can get out over a period of time only what you put in.”
Photo: Norm Stein. Courtesy: Drexel University School of Law.
The Pension Rights Center, a Washington-based consumer group, supports Stein’s view that participants in 401(k) plans should not take money out of their accounts, but notes it is a Catch-22.
“On the one hand, the PRC feels that retirement plans are tax-subsidized and the money should stay in the 401(k). But on the other hand, if someone is struggling, what do we do? Unless the government has policies to ensure every family is taken care of, you will have these contradictions,” said Karen Friedman, executive vice president and policy director of the center.
“It’s a problem because retirement plans are essentially serving so many different purposes. They have become the ‘everything plan.’ But the truth is if you are using it for all purposes, it’s not serving its primary purpose. That is a reason why we have a retirement crisis and (that) it will get worse over time.”
King of the New America Foundation advocates for a system that allows families to have a more diversified savings portfolio.
“One of the big unsupported areas is what we can do to promote emergency savings and families having a flexible nest egg that becomes the place they go to when something happens so they don’t have to go to their retirement plans,” he said.
“There is nothing there on the emergency savings side. We need to think creatively about how we can change tax structures and employee benefit structures to establish a stable foundation.”
One thing on which everyone agrees is that education is critical. “To the extent that employers offer financial education in concert with products to which they connect employees, it’s an important way for them to think about their long-term financial stability,” said King.
O’Connor, for one, said if he had had more information about the perils of taking that $24,000 out of his 401(k), he definitely would have thought twice.