Senate Bill Would Limit Savers Using 401(k)s as Rainy-Day Funds

They're Getting Reday To Go After Your 401K's
Workers will be limited in tapping their 401(k) retirement plans for loans under legislation two senators introduced today that’s designed to counter the erosion of retirement assets.
“Because of the difficult economic times, more and more Americans are treating their retirement accounts as rainy day funds,” Senator Herb Kohl, a Wisconsin Democrat, said in a statement today. “A 401(k) savings account should not be used as a piggy bank.”
Kohl, 76, who’s chairman of the Senate Special Committee on Aging, introduced the “SEAL 401(k) Savings Act” with Senator Mike Enzi, 67, a Wyoming Republican. The bill would reduce the number of loans workers may take from a 401(k) and give participants more time to repay after losing a job. It will allow savers to contribute to their plan after taking a hardship withdrawal and ban debit cards linked to the accounts, according to the legislation.
The Senate bill would limit the number of outstanding loans for each participant to three. Employers would have the option to reduce the number for their plans, said Joe Bonfiglio, a spokesman for Kohl’s aging committee. There is no rule right now limiting the number of loans workers may take and it varies by company, Bonfiglio said.

Leaving a Job

Almost 28 percent of participants in 401(k)-type accounts had an outstanding loan at the end of 2010, which is a record, according to a study released today by benefits consultant Aon Hewitt, a unit of Chicago-based Aon Corp. (AON) The average outstanding loan balance was $7,860 and 58 percent of plans permit participants to have two or more loans at a time, said Aon Hewitt, which used a database of about 2 million employees in 110 plans.
“The big risk with loans is that participants leave their job,” said Alison Borland, head of retirement strategy for Aon Hewitt. Most 401(k) plans require employees to repay loans in full when leaving a job, usually within 60 days, said Borland, who’s based in Nashville, Tennessee. Almost 70 percent default, Borland said, so the unpaid funds get counted as taxable income and may add to the burden of a jobless worker.
Depending on the rules of an employer’s 401(k) plan, workers generally may borrow from their retirement account for any reason and pay the loan back with interest. About 89 percent of participants were in plans offering loans in 2009, according to the Washington-based Employee Benefit Research Institute, which has a database of 21 million 401(k) savers.

Payroll Deductions

Workers generally may borrow as much as 50 percent of their vested account balance up to a maximum of $50,000, according to the Internal Revenue Service. The loan must be repaid within five years, unless the money was used to buy a primary home.
Employees can repay the loan through payroll deductions and can continue to make contributions to their retirement accounts, Borland said. More than 80 percent of those with a loan do continue to save, she said.
“For these workers who take a loan, repay it and continue to save, they haven’t done significant damage to their retirement prospects,” Borland said. “They are at significant risk if they change jobs or lose their job.”
The average interest rate on loans from 401(k) plans is the prime rate plus 1 percent, currently 4.25 percent, David Wray, president of the Profit Sharing/401k Council of America, said in an e-mail. The median loan origination fee in 401(k) plans is $75 and the median annual loan maintenance fee is $25, according to the council, a Chicago-based non-profit association of employers that sponsor retirement plans.

Tax Penalty

“Our bill would allow for a greater period of time for the loan to be paid back thereby helping families pay back the loan and allowing the funds to be put back into their retirement savings and avoid the tax penalty,” Senator Enzi said in a statement today.
For workers who lose their jobs before repaying a loan, the bill would let them pay down their balances into an individual retirement account before filing their taxes for that year. The IRS and Treasury Department would need to issue guidance on how the process will work, Bonfiglio of the aging committee said. About $663 million of 401(k) loans in 2008 were deemed taxable distributions, according to a December report by the Department of Labor.

Loan Flexibility

The flexibility to take loans or withdrawals is an attractive feature of the accounts for some participants, said Sarah Holden, senior director of retirement and investor research for the Investment Company Institute, a mutual-fund trade group based in Washington.
“Knowing that you can borrow the money if you need to frees people to participate in the plan and contribute more,” she said.
About 19 percent of participants in 401(k)-type plans rate their efforts toward reaching retirement goals as “very effective” and only 16 percent are “confident” they will have enough money to retire on time, according to a survey released today by BlackRock Inc. (BLK) The New York-based money manager has more than $325 billion in defined contribution assets under management, according to the report.
A 401(k) plan’s terms also may let individuals take a hardship withdrawal that doesn’t have to be repaid if the borrower demonstrates a financial need such as medical or funeral expenses. That money generally is included in an employee’s income for tax purposes and may trigger an additional 10 percent tax penalty, according to the IRS. Employees also are generally prohibited from making contributions to their account for at least six months after taking the withdrawal, the IRS said.

Contributions Can Continue

The legislation would allow participants to continue to contribute during the six months following a hardship withdrawal because the loss of employee and company matching contributions during that period can further erode retirement savings, according to Kohl’s statement. Kohl said on May 13 that he won’t seek re-election next year.
The bill also would ban products that promote so-called leakage of savings including 401(k) debit cards, which may carry high fees. While use of 401(k) debit cards is not widespread, they have been offered by companies in the past, Bonfiglio said. Using the card essentially triggers a loan.