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Strapped workers cracking 401(k) nest eggs

More people are jeopardizing their future by raiding their retirement savings for immediate needs.

September 03, 2008|Nancy Trejos | The Washington Post

Six months ago, Ivan Sanchez was optimistic about his future. He had recently earned a bachelor's degree in business management and was writing a book about growing up among gangs and guns in the Bronx.

Then he was threatened by something else: a credit card bill, student and car loan debt, higher gas bills and rising rent. With two high school-age children in need of clothing and school supplies and a toddler in need of much more, it didn't take long for Sanchez's optimism to fade. That's when he decided to do what any financial planner would advise against: He dipped into his 401(k) retirement plan.

"There's no other way I could do it," said Sanchez, a 35-year-old Virginia Beach, Va., resident.

Hard economic times are driving some people to take actions that could jeopardize their future. With home equity lines of credit and other types of loans harder to get, employees are increasingly raiding their retirement plans to take care of immediate needs such as paying down debt and medical bills, staving off foreclosure or simply covering higher food and fuel prices.

"People are overextended in their personal financial lives and are looking for any way to find money to help them weather the storm they are going through right now," said Andrew McIlhenny of Firstrust Financial Resources, a wealth management firm in Philadelphia.

There are two ways people tap into their nest eggs. They can take hardship withdrawals, which require proof of a severe financial need. Or they can get a loan, which they have to pay back, usually within five years. Not all employers will permit either one, but those who do impose different rules and fees. One thing is the same, however: Taking a withdrawal or loan can have a long-term negative effect, advisors and plan providers said.

The pickup in withdrawals is a worrisome trend, financial advisors and plan administrators said, because 401(k) plans are replacing employer-sponsored pension plans and Social Security as the main source of retirement savings for many Americans. Over the last two decades, as participation in 401(k) plans has quadrupled, politicians and employers have urged Americans to treat them as sacred. Yet some banks have started offering debit cards linked to accounts with money from 401(k) loans.

"With the increase in credit card debt, with the increase in plan holders and the availability of borrowing against a 401(k), I think that society is starting to view it as more than a retirement plan but as kind of like an alternative way to get cash," said Pamela Villarreal, senior policy analyst for the National Center for Policy Analysis in Dallas.

Some of the nation's largest 401(k) plan administrators have reported increases in hardship withdrawals. At T. Rowe Price, withdrawals were up 19% in June compared with the same period last year. At Vanguard, they increased 8.6% in 2007 from the year before.

Hewitt Associates, an Illinois-based human resources consulting company that tracks 401(k) trends across the country, found that 5.4% of plan participants took hardship withdrawals in 2007, up from 4.9% the previous year. That followed several years of declines after a peak of 6.2% during the 2002 recession.

To make such withdrawals, employees have to prove that they need the money immediately and that they don't have extra money lying around. The Internal Revenue Service has a list of approved reasons, such as medical expenses that insurance won't cover, payments to avoid eviction or foreclosure, funeral expenses and college tuition. The withdrawal is counted as income and subject to tax. On top of that, there is a 10% penalty if the employee is younger than 59 1/2 . And for six months after the withdrawal, the account is essentially frozen: Neither the employee nor the employer can contribute money to it.

Plan providers point out that the percentage of employees taking withdrawals is small. At Fidelity Investments, for instance, it is only 1.6%. But with about 44 million people across the nation with private-sector 401(k)-style plans, even a small percentage can translate into hundreds of thousands of withdrawals.

A far greater number of employees took loans because they are easier to get than withdrawals and bank loans that require credit checks. They also are attractive because, depending on the provider, the interest rates tend to be low, usually the prime rate plus one or two percentage points. Most plans allow employees to take a loan for any reason. But there is a law forbidding employees from borrowing more than $50,000 or half of the vested account balance, whichever is less. And if they leave their jobs before the loan is repaid -- or if they lose their jobs, as is more likely in this economy -- they have to pay off the balance soon after or incur the income tax and 10% penalty of a hardship withdrawal.

For 2007, the Transamerica Center for Retirement Studies found that 18% of more than 2,000 full-time employees surveyed had taken out loans, compared with 11% the previous year. Nearly half said they did it to pay off debt.

"Throughout the survey, we found a recurring theme of people struggling with short-term financial priorities versus their long-term retirement savings, and unfortunately things like 401(k) loans have become sort of not the best solution but a quick and easy solution," said Catherine Collinson, president of the nonprofit center.

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