More Consumers Are Tapping 401(k) Loans

CU360
March 3, 2009 | COMMENTS

During these tight economic times, more consumers are facing unexpected medical or other bills that they're unable to pay from current income. Those who have saved a nest egg for retirement through a 401(k) plan have an option—they can borrow against that to keep the bill collectors at bay. Since the money is theirs, there's no approval, and they can borrow up to half of their retirement savings with no penalty, so long as they pay it back within five years.

But there's bad news too, and a disturbing national trend, according to a report from the Center for American Progress. While the money loaned is out of the retirement account, there's no investment return. Should the borrower fail to pay the loan back, he or she will have to pay taxes on the amount plus a 10% penalty. Finally, any interest payments on the loan are still helping to grow retirement savings, but they're paid in after-tax dollars, and the borrower will have to pay taxes again on that "gain" when receiving payments in retirement.

Given the significant downsides to 401(k)-type loans, why do people take them? In part, because they're either uninsured or underinsured for the risks they face. Over the past few years, families looked for new ways to bridge the gap between slow income growth and rapidly rising prices. This search often led them to household credit, but as families amassed ever-larger amounts of household debt they sometimes also sought out additional financial resources, such as their retirement plans.

Now, as effects from the housing crisis continue, more individuals are tapping their 401(k)s. Most defined-contribution retirement plans—now widespread—allow individuals to borrow from their 401(k)s. The result is that families leverage their future retirement security to ease their present financial insecurity.

Data compiled by the Center show that:

• Even with a fairly modest loan amount of $5,000, a worker's retirement savings could be substantially reduced. For instance, a 401(k) plan participant who takes that loan and makes only the loan payments reduces total retirement savings between 13% and 22%.
• Loans from defined-contribution plans have risen sharply. Over a period of 15 years, loans against retirement savings accounts increased almost five-fold in inflation-adjusted terms, to $31 billion in 2004, up from $6 billion in 1989—an increase of almost 400%.
• Despite beneficial interest rates, loans from defined-contribution plans add to the overall debt burden and do not seem to substitute for other forms of debt. 401(k) plan participants who borrowed from their plans had median debt payments relative to income equal to 22.5% after 1995, while those who did not borrow paid only 18%.
• Demographic changes include 401(k) borrowers becoming more equal by race and ethnicity, with loans among white plan participants relatively more likely than among their African-American or Hispanic counterparts.
• Middle-class families in particular rely on their retirement savings accounts to provide them with easily accessible loans, particularly when they buy homes, experience a spell of unemployment, or are burdened by bad health.

The data indicate a growing trend. As the economy slows, and with other loan sources—particularly home equity lines—closed off due to lower house prices and tighter credit standards, families are turning increasingly to their 401(k) plans. "The data through 2004 is a harbinger of the erosion in retirement security to come as families are economically squeezed from all sides," according to the Center.

The full report, Robbing Tomorrow to Pay for Today, is available online from the Center for American Progress here.