New Funding for the Consumer – Their 401(k)??

According to the WSJ, there appears to be an increase in borrowing from 401(k)s. It appears to be small, but is noticeable. This article is especially good because it does not go into all the “preachy” stuff about why you should not borrow from a 401(k). Instead it dwells on the tax consequences of borrowing from your 401(k). Those alone should scare you into not borrwoing from your 401(k).

Despite potential tax and investment consequences, more individuals have been borrowing from their 401(k) plans or taking hardship withdrawals in recent months, some retirement-plan providers say.

Not all plans have seen jumps, and more-comprehensive statistics won't be available until next year. But a number of plan providers that follow month-to-month patterns, including T. Rowe Price Group Inc., Hewitt Associates and Hartford Financial Services Group Inc., have seen a small but noticeable uptick.

Many in the field expect more 401(k) borrowing in 2008 as consumers struggle with tighter credit and potentially higher mortgage payments.

"I don't think it's a groundswell, but it's enough to be noticed," says Rick Meigs, president of 401khelpcenter.com, which provides information on 401(k) plans.

To be sure, the indications are preliminary, and some big providers, such as Fidelity Investments, say they haven't seen any increase in 401(k) borrowing. About 20% of Fidelity 401(k) investors have a loan, a figure in line with the industry. (my emphasis, why am I surprised the number is that high.?)

Even those firms that are seeing increase in 401(k) borrowing aren't sure what to ascribe it to, though financial advisers say it could be due to the effects of the credit crunch and slumping housing prices.

"A few years ago, the buzz was about borrowing from a 401(k) to buy a second home," says Jeff Carbone, a financial adviser in Cornelius, N.C. "Now it's people looking at their 401(k) because they've extended themselves on their homes and credit lines."

Most plans allow borrowers to take money out of their 401(k) accounts to pay tuition, purchase a residence, pay medical or funeral expenses, or to avoid eviction or foreclosure. Borrowers must repay the loan plus interest, which is typically set at one or two percentage points above the prime rate.

While plans vary, the most you can borrow is the lesser of 50% of your vested balance or $50,000.

Employees usually must repay money borrowed for a mortgage within 15 years, and money used for other purposes within five years. If you fail to pay back the loan on time and are younger than 59½, you're subject to regular income tax and an IRS penalty tax of 10% for early withdrawal.

Though borrowing against your retirement nest egg may seem tempting, it could significantly reduce your savings at retirement and create an expensive tax bill if you can't repay the loan when it is due.

Tom Foster, a national spokesman for Hartford's retirement plans, says that he considered borrowing from his 401(k) when he was saddled for more than a year with an extra mortgage, but decided against it.

"Most Americans see this as a panacea, but instead it erodes time in the market and adds a new payment," he says.

Even a person who pays such a loan back on time, and therefore avoids the 10% penalty, is getting taxed twice, says Bill Arnone, a partner at Ernst & Young LLP -- once when repaying the loan with after-tax dollars, and a second time when the money is withdrawn at retirement. (my emphasis)

People who take the loans also lose out on potential retirement earnings while the money isn't invested.

Should you lose your job, the costs could be even higher. Borrowers who are fired, laid off or quit typically have to pay off the loan within 90 days, or face additional taxes and penalties, says Stuart Ritter, a financial adviser at T. Rowe Price.

David Wray, president of the Profit Sharing/401(k) Council of America, a not-for-profit association of companies that sponsor plans, expects that higher payments on adjustable mortgages will have people "looking for ways to make up that gap," and "a significant number of people with 401(k) plans are going to be affected."