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Think Twice Before Taking a 401(k) Loan: Congress

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If you’re thinking about borrowing money from your retirement savings, Congress wants you to think twice.

Legislation introduced last week in the Senate seeks to curb loans from 401(k)s and related retirement plans. The proposal coincides with a new study from Aon Hewitt, a management consulting firm and unit of Chicago-based Aon Corp., which shows that – in the wake of the recession – a record number of people are dipping into their nest eggs before retirement.

At the end of 2010, more than one-quarter (27.6%) of participants in defined-contribution plans had a loan outstanding, according to Aon Hewitt. The average loan balance was $7,860, which accounted for 21% of the participants’ total plan assets. Perhaps most worrisome, almost three out of 10 participants (29.2%) had two loans outstanding, and 2.5% had more than two loans. (The majority of plans, 58%, allow employees to have two or more loans outstanding.)

Yes, you might know that borrowing from retirement savings isn’t the best of ideas – but few people realize that they’re penalizing themselves three times in doing so.

First, you’re costing yourself a potentially significant amount of interest. (After all, when you borrow money from a 401(k), your nest egg is smaller and earns less money.) Second, when you pay back the loan, you’re using after-tax dollars; by contrast, contributions to a 401(k) are made with pre-tax funds. Third, such loans aren’t tax-deductible. (That compares with a home-equity loan, for instance, which allows you to deduct the interest on your taxes.)

A worst-case scenario is a person with a loan outstanding who loses his or her job. Most retirement-savings plans, according to Aon Hewitt, require employees to repay loans in full – usually within 60 days – once they walk out the door. In such cases, almost 70% of workers default on repayment. The upshot: The unpaid funds are considered taxable income, which can add to an unemployed individual’s financial burdens.

How does all this affect your retirement security? Aon Hewitt estimates that employees (in the early to middle part of their careers) who take a five-year loan – and, as a result, aren’t contributing to their nest eggs for that period of time – will see future retirement income fall 10% to 13%. With two loans, the drop-off nearly doubles.  (Click here to figure out how much it will cost you to borrow from your 401(k) or 403(b)?)

The Senate bill, introduced by Wisconsin Democrat Herb Kohl and Wyoming Republican Mike Enzi, seeks to ease some of the pressures on borrowers, as well as make it somewhat tougher for workers to take out loans in the first place. Called the SEAL Act (Savings Enhancement by Alleviating Leakage in 401(k) Savings), the legislation would:

– Extend rollover periods. Instead of an immediate repayment (or possibly defaulting), borrowers who lose their jobs could contribute the amount outstanding on their loan to an individual retirement account by the time they file their taxes for that year.

– Allow contributions to plans following hardship withdrawals. Normally, a worker who receives a hardship withdrawal from a 401(k) (for, say, medical expenses) can’t contribute to retirement savings for at least six months. The act would end that ban.

– Reduce the number of loans. Plan participants would be limited to no more than three loans at any one time. (Currently, employers set the number of loans available.)

– Ban products that promote “leakage.” Example: debit cards that are linked directly to a person’s retirement savings plan.

You can see the full text of the bill here.

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    • congress can KISS MY A**!!!! How about they write a bill to quit borrowing EVERY YEAR and adding to the deficit. IDIOTS!!

    • Wow, $7860 loan = 21% of the 401(k)? You realize that 401(k) is worht about $37,500? Really? Why bother? Calculate the lost earnings, plus the interest and you are still talking about less then a cup of starbucks coffee. Why bother with the whole 401(k)? The whole thing is a sham anyway. It’s nothing more than a guaranteed income stream for the IRS. There will be lots of ‘you’re an idiot” comments, but you are better off in a universal life or whole life program; roi, liquidity and freedom over your money. First thing everyone should do is operate their entire financial life out of a line of credit. That’s right, a line of credit. Do what I did; truthinequity.com. These people are brilliant!!! Abandon EVERYTHING YOU’VE EVER BEEN TAUGHT ABOUT MONEY. Start over! Go talk to these people!

About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.

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