As the Obama administration continues to look for ways to ease the financial pain that people are feeling in this recession, I hope it will provide relief for the many folks who are facing huge tax bills because of 401(k) loans.
For some, a 401(k) loan can be an appropriate bailout during difficult times. After all, you’re borrowing your own money from your retirement plan and paying it back in monthly installments over five years, unless the loan is used to buy a primary residence. Plus you are paying interest to yourself — typically the prime rate or prime plus 1 percentage point.
But if you leave your job, either voluntarily or you get laid off, the loan becomes due within 90 days. If you default, it will be costly.
First, the loan amount is subject to federal and state income taxes because the loan disbursement is considered taxable income. Remember, when you put money into a 401(k), it is not taxed. On top of the taxes due, if you are younger than 59 1/2, you have to pay a 10 percent penalty for early withdrawal.
For a laid-off worker with no immediate job prospects, the penalty and pending tax bill can be financially devastating. With all the temporary measures flying through Congress, it seems logical and compassionate to give a reprieve — if only temporarily — to employees who took out 401(k) loans and now can’t pay them back.
In a report earlier this year, the Federal Reserve said that in its 2007 Survey of Consumer Finances, the share of eligible households with 401(k) loans was about 15 percent.
Interestingly, the Fed report — “New Evidence on 401(k) Borrowing and Household Balance Sheets” — breaks with conventional wisdom that it’s always a bad idea to borrow from your 401(k). Fed economists Geng Li and Paul A. Smith contend that tapping your retirement money can be a better move than using high-cost consumer credit.
The economists estimate that households could have saved as much as $5 billion in 2007 by shifting expensive consumer debt to 401(k) loans, or about $275 a year per household.
I generally dissuade people from borrowing from their retirement funds unless it’s absolutely necessary. When you pull money out of a retirement account, you lose whatever return you might have gotten on the portion of the cash not yet repaid. And although employees have seen their 401(k) balances drop by 30 percent or more recently, over the long haul portfolios have traditionally shown gains.
If that’s not a good enough reason, then how about the risk of losing your job and having to pay back the loan in a short time? That’s a real possibility for many workers in this economy.
Li and Smith suggest two changes that would reduce the risk of 401(k) borrowing. The first would make 401(k) loans “portable.” Loan servicing could roll over to a new employer after a job change, along with the account balance, the economists argue.
“This would allow participants to continue to repay outstanding balances over time via payroll deduction,” Li and Smith write.
Second, employers could be required to continue servicing the loans of their unemployed workers. This would allow laid-off workers to keep making monthly 401(k) loan payments rather than coughing up a lot of cash within the 90-day window.
Li and Smith acknowledge these changes would impose some new requirements on employers. And I’m sure employers would complain about the added work. But it would make borrowing from a 401(k) less of a burden for people going through a period of unemployment or for others changing jobs.
“Households are often better off financing consumption out of their own assets instead of by borrowing from outside lenders,” Li and Smith conclude. “Allowing participants some pre-retirement access to their savings can increase 401(k) participation and contributions, particularly among younger and more liquidity constrained households. Given that 401(k) loan programs exist, it seems appropriate to design them in a way that minimizes financial risks to participants and maximizes 401(k) participation and contributions.”