Resist urge to raid retirement funds early

Would you still put money in a tax advantaged retirement fund if you couldn’t touch it until you retired?

And when I say you couldn’t touch it, I mean you couldn’t take out loans or withdraw funds under any circumstances.

If Congress were rewriting the rules for 401(k)s and similar retirement plans, that’s what the Washington-based Pension Rights Center would recommend. Why this hard stance from a consumer-oriented group that works hard to protect and promote retirement savings?

A new study has found an increasing number of employees are raiding their retirement funds by taking out loans against their 401(k) accounts. Strangled by debt and rising consumer prices, workers are turning to these plans as the only stash of cash they have.

“The result is that families leverage their future retirement security to ease their present financial insecurity,” wrote Christian E. Weller and Jeffrey B. Wenger, who authored “Robbing Tomorrow to Pay for Today: Economically Squeezed Families are Turning to Their 401(k)s to Make Ends Meet.” The report was issued by the Center for American Progress.

Last week, the U.S. Senate Special Committee on Aging held a hearing to examine this trend and hear solutions on how to reverse it. The CAP report was released at the hearing.

In it, researchers found that over a 15-year period, loans against retirement savings accounts increased almost fivefold in inflation-adjusted terms, to $31 billion in 2004, up from $6 billion in 1989 – “an increase of almost 400 percent.” Between 1998 and 2004, an average of 12 percent of families with 401(k) plans borrowed from them.

Although much of this money was paid back, the drain from accounts is significant. Even with a fairly modest loan amount of $5,000 in 2008 dollars, a worker’s retirement savings could be substantially reduced. For instance, a 401(k) plan participant who takes out a loan to smooth over a rough patch, then makes only the loan payments, reduces the total retirement savings between 13 percent and 22 percent, the report noted.

The study also found that increasingly, middle-income families are raiding their retirement funds.

The increase in 401(k) loans is so high because this money is so easy to borrow. If your plan allows such a loan, you can borrow $50,000 or one-half of the vested balance from your retirement account, whichever is lower. The loan has to be repaid in five years or less, except for loans that have been taken out for the first-time purchase of a home. That loan can be repaid over a period of up to 15 years.

Additionally, the interest rates on 401(k) loans are generally very reasonable. For instance, in 1996, about 70 percent of the 401(k) plans that allowed borrowing charged an interest rate equal or less than the prime rate plus one percentage point, while less than 10 percent charged an interest rate equal to the local bank’s lending rate, the report said.

Here’s what’s wrong with borrowing from your retirement fund, as laid out in the report:

¢ When you take the money out of your retirement account, you lose the possibility of investment earnings.

¢ You may be paying yourself back with interest, but that interest is at a below-market rate of return.

¢ If you fail to pay the loan back, you will have to pay taxes on what you took out in addition to a 10 percent penalty for the early withdrawal.

¢ You pay back the money in after-tax dollars

In a statement, the Senate committee’s chairman, Herb Kohl, D-Wis., said, “When a participant can use his or her 401(k) to make everyday purchases like buying a cup of coffee, clearly that is a gross distortion of the plan’s intended use.”

I’ve worked with a lot of people in debt and not a single person recklessly robbed their retirement account to pay for a latte. It’s not conspicuous consumption that is pushing up the numbers of 401(k) loans. It’s more likely the result of health problems or job losses.

But Kohl and others are right to be concerned.

I agree that there needs to be a stopgap for allowing people to borrow from their retirement funds. We should have a policy that discourages withdrawals for home purchases or to pay for college expenses. This pot should be reserved for retirement.

Loans from a 401(k) plan should only be allowed in dire situations, such as a job loss, disability, or major medical illness.

Changes to the loan policies are needed. But it would be hard to persuade people to fund an account they had no access to under any circumstances. That’s neither realistic nor is it compassionate.