401 (K)

The Danger of Treating Your 401(k) As a Piggybank

Your 401(k) retirement account is meant to be a nest egg, but more employees than ever are treating these accounts as piggybanks these days, taking loans and withdrawals. Unfortunately, these moves could come back to haunt them.

“It’s never a mistake to put too much money into a 401(k) plan,” says Scott Tuxbury, director of retirement and investments with New Wealth Advisors in Tewksbury, Mass.

“The mistake is using these balances, not as a retirement account, but as a rainy day account.”

Don’t get us wrong. Borrowing from a 401(k) isn’t always a bad move—if you’re borrowing for sound reasons and are sure you can pay it back, it can be better than running up high interest credit card debt. But borrowing can also be an indication that there are problems with the way you’re managing and protecting your retirement savings.

Consider the new client Tuxbury met with last fall—a 55-year-old woman making $110,000 a year, who was in 401(k) paralysis. Back in 2007, when her 401(k) was worth $230,000, she took out a $50,000 loan (the maximum allowed by law) to pay for a daughter’s wedding. (We’ll leave others to comment on the wisdom of borrowing so much for a wedding.) Then, in 2008, during the stock market crash, the woman’s balance declined another $80,000. Panicked, she moved what was left all into fixed income investments (missing the stock market recovery) and stopped making new contributions altogether.

Tuxbury helped her undertake a complete family 401(k) makeover. She’s started contributing again, is paying the loan back over five years (as required by law), and has moved funds back into equities. Her husband, despite a $100,000 a year income, had only a $20,000 401(k) from a former employer and wasn’t contributing to a 401(k) at a new job. Now he is maxing out contributions. “They understand the severity of the matter,” Tuxbury says, adding that they are rethinking spending plans too–maybe they don’t really need that new Jacuzzi and deck they had planned to add to the back of their house.

Is it too easy to get money out of retirement accounts? Maybe, maybe not. If you couldn’t borrow from a 401(k), some workers might be more reluctant to put their money into one. But just because you can borrow, doesn’t mean you should.

The percentage of 401(k) participants who had an outstanding loan in 2010 was 28%, a record high, according to a recent Aon Hewitt report, “Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income.” Moreover, even before the recession, the percentage had been steadily rising; it was 21% in 2006; 22% in 2007; 23% in 2008; and 26% in 2009. Just as worrisome, a third of those with outstanding loans in 2010 had two or more loans outstanding at once.

While folks of all ages take 401(k) loans, those who are in their 40s and earning between $40,000 and $60,000 are most likely to have outstanding loans, the report found. That’s not too surprising. After all, by their 40s, folks should have substantial balances from which they can borrow, and may be facing special costs, for kids’ college tuition and the like.

In such circumstances, a 401(k) loan isn’t necessarily bad —if you pay it back. That’s a big “if.” You have to pay back principal and interest (with after tax dollars) on a schedule, and if you default, the remaining amount of the loan counts as a taxable distribution (that means it’s added on to your income at tax time). Moreover, if you’re under 59.5, there’s also a 10% early withdrawal penalty tacked on.

The biggest risk for default is if you lose your job. Generally you have to pay back the loan in full within 60 to 90 days of termination. It’s the same deal if you quit. “You find people borrowing and six months later they give notice, and all of a sudden they have this big tax bite they weren’t planning on,” says Robert Demmett, a CPA with EisnerLubin in New York City.

When employees with loans terminate employment, nearly 70% subsequently default on the repayment (versus less than 3% of active employees), according to the AON Hewitt report.

An aerospace engineer with the Department of Air Force, Raymond Ryan, learned this the hard way. In 2003 at the recommendation of a coworker —not usually the best place to get 401(k) advice, although commonplace–he took out a $50,000 general purpose loan from his TSP account to pay off debt and buy a parcel of land. (The TSP is the equivalent of a 401(k) for federal employees.)

Less than two years later, the Air Force reassigned Ryan from Texas to Oklahoma and he failed to report to duty, citing medical reasons. The Air Force put him on AWOL status, and his plan closed his loan, despite the fact that he kept making payments and told his plan that he was appealing his removal from service. Long story short, a U.S. Tax Court judge has just ruled that Ryan, who paid the income tax due on the early distribution in 2006, now has to pay $979, the 10% early distribution penalty, too.

For general purpose loans, the total outstanding principal cannot exceed the lesser of 50% of your account balance or $50,000. So someone with a $120,000 401(k), could take $50,000 and someone with a $40,000 401(k) could take a loan of up to $20,000. The term of the loan must be five years or less.

In addition to general purpose loans, many plans allow special loans for the purchase of a home (your primary home, not a vacation home). In such cases, the length of the loan can exceed five years. Watch out: this doesn’t apply for home improvement loans or a refinancing, notes Glenn Sulzer, a senior pension law analyst at CCH, a Wolters Kluwer company. And read the fine print. Application fees and annual service charges are usually higher for residence loans.

In addition to loans, some employees have been raiding their 401(k)s by taking what’s called a “hardship” withdrawal. These are allowed for medical or educational expenses, burial or funeral expenses, and costs associated with avoiding eviction or foreclosure. But these really should be a last resort. Hardship withdrawals are always included in income (you don’t put the money back into the plan), and if you’re under 59.5, the 10% penalty applies. Another downside: for six months after making a hardship withdrawal, you’re not allowed to make new contributions to your 401(k), further eroding your retirement stash.

Once you reach 59.5, you face even more temptations. That’s because many plans let employees take in-service withdrawals, a fine move if you don’t like your plan and you’re rolling the funds over to an Individual Retirement Account, but a dangerous one if you’re taking the money out to spend. Similarly, Tuxbury say, the biggest 401(k) mistake he sees is retirees who get lump sum checks sent to them in the mail and deposit the full amount in their bank account. “You’ll see a real spike in expenditures,” he says. “They’ve always wanted that Cadillac.”

10 Steps To Boost Your 401(k) Balance:

Can you reach the max?

The maximum amount an individual can save in a 401(k) is $16,500 a year, or $22,000 if you're 50 or older. For 2012, it’s $17,000 or $22,500 if you're 50 or older. If that's attainable, go for it. If it sounds like a long shot, consider these smaller moves that can help get you to a bigger 401(k) balance.

Grab your employer match.

Many employers suspended 401(k) matches during the great recession, but they are starting to reinstate them. Make sure you contribute at least enough to get the matching contribution.

Save your annual salary increase.

If you get a raise, consider bumping up the amount you save in your 401(k). If you get a bonus, earmark a piece of it to go into your 401(k).

Reset your contribution rate mid-year.

Typically you set the percentage of your pay you want to contribute to your 401(k) when you start a new job or during a special "open enrollment" time. But most employers let you change your contribution amount mid-year.

Go Roth!

If your employer offers a Roth 401(k), consider it, especially if you're on the younger side. The contribution limits are the same for a Roth 401(k) or a regular 401(k), but with a Roth you contribute already-taxed dollars and then withdrawals in retirement are tax free.

Don't use your 401(k) for loans.

Most employers allow employees to take loans from their 401(k)s and lots of employees take them. The problem is that many end up not paying themselves back, basically robbing their retirement kitty. Another danger is if you switch jobs or are laid off, the loan is due immediately, and if you can’t pay it off, penalties as well as regular taxes apply.

Not everything is a hardship.

Beyond loans, hardship withdrawals are allowed under special circumstances. If you read the rules wrong, you could be required to repay the amount you took out plus earnings. For example, a hardship withdrawal is allowed if you're in foreclosure proceedings but not just because you're a few months behind on your mortgage payments.

Get your spouse to save.

If you and your spouse both have access to a 401(k) plan, you should both be contributing as much as you can. In some cases, high earners may be told they can't contribute as much as they'd like because of "non-discrimination rules," and that makes it all the more important for a lower-earner spouse to be saving to the max.

Consolidate accounts.

Have one or more old 401(k) accounts? Roll over your old 401(k) account balance into your current employer's plan, assuming it offers decent low-fee investment choices. By having one 401(k) it's easier to stay on top of things.

Don't go on autopilot.

Lots of folks pick investments when they first sign up for a 401(k) and don't get around to revisiting their choices. Check that your asset allocation still makes sense, that you're not in high-fee funds that eat away at your returns, and consider some of the newer investment choices in 401(k)s, including target date funds, international funds and low cost collective trusts. Don't overload your account with company stock just because it's available.

Don't cash out early.

Once you reach 59.5, don't be tempted by the ability to take money out penalty-free while you're still working, or to "cash out" when you retire. Instead leave the funds in your old 401(k) if it's a good plan with decent investment choices and fees, or alternatively roll it into an Individual Retirement Account, which like a 401(k) continues to grow tax-deferred. You'll be thankful when you're older.