Raiding 401(k) Plan

April 7, 2008
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GRAND RAPIDS — Volatile market conditions combined with the credit crunch and economic uncertainty are driving more and more employees to tap their retirement nest eggs to meet basic living expenses, pay off debt or fend off home foreclosure. It’s a trend that has financial advisers concerned.

A recent Transamerica Retirement Survey revealed that nearly one in five employees — 18 percent — took out a loan from their retirement plans last year, up from 11 percent in 2006. Some 49 percent of them cited the need to pay off debt, a figure that was up from 27 percent in 2006. Yet nearly half of those surveyed indicated that they expect to rely on their 401(k), 403(b) and IRAs to support their retirement.

“While a loan from your 401(k) plan seems like an obvious choice when you’re in need of money, many are unaware that this short-term solution can often create more problems,” stated Catherine Collinson, market and trends expert for the Transamerica Center for Retirement Studies.

“Once you terminate employment, most retirement plans require that you repay the loan in full or it will be considered a taxable distribution in which regular income tax applies, and — if you are under age 50.5 — an additional 1 percent penalty applies.”

An analysis conducted by JPMorgan Chase & Co. showed that 401(k) participant behavior was “much more varied and volatile than most industry models assume.” That conclusion was based on a quantitative analysis of the withdrawal patterns of 1.3 million 401(k) participants across 350 plans nationwide whose accounts are administered by JPMorgan Retirement Plan Services. The study found that the number of people taking either a loan or “hardship withdrawal” from their 401(k) is on the upswing — up 7 percent since mid-2007.

At the Business Journal’s request, Anne Lester, managing director and senior portfolio manager of JPMorgan Chase’s Global Multi-Asset Group, looked specifically at the data for Michigan and the broader Midwest region to see how they stacked up against the rest of the country. There were only four Michigan plans among the 350 analyzed nationwide, Lester noted, so, because it’s a very small data set specific to those four companies, caution must be exercised to not over-generalize the results.

On average, 22 percent of participants in the Michigan plans had 401(k) loans outstanding over the past few years, compared to 19 percent to 20 percent of participants in the aggregate 350 plans. The data reveal that the number of people taking loans from their 401(k) rose by 5 percent in Michigan in the second half of 2007. Lester said she wouldn’t make too much of the slightly lower percentage rate in Michigan compared to the national average because the same basic pattern is being seen all over the country.

What’s interesting for Michigan, Lester said, is that it’s home to two of the top 100 cities with the highest foreclosure rate, which puts Michigan among the top five states for total foreclosure rates, behind California, Florida and Ohio. The Midwest also has the second highest foreclosure rates among the country’s regions, and those rates have increased more than 120 percent over the past year, according to Chase’s data.

Chase found that increased 401(k) loans and hardship withdrawals were greater in parts of the country where foreclosure rates were high. In the South Atlantic, Midwest and Southwest regions, more than half of company 401(k) plans have experienced an increase in loans and withdrawals since 2006.

“We did see a very similar pattern in Michigan in terms of the decrease in 401(k) loans outstanding — not the size of the loans, necessarily, but the number of individuals who had outstanding loans decrease from 2005 through the middle of 2007 by about 17 percent. Then it turned around and started increasing again by 5 percent from the middle of 2007 onward,” Lester said. That change coincided with the beginning of the housing and credit market turmoil, she noted.

The change in the Midwest region was less dramatic. Chase saw an 11 percent decline in 401(k) loans outstanding between 2005 and mid-2007, but didn’t see much increase in the average percent of participants with a retirement loan outstanding in the second half of 2007.

The IRS code governing 401(k) plans provide for hardship withdrawals for “immediate and heavy financial need,” which typically applies to problems such as foreclosure, bankruptcy or medical emergency. The tax penalty for a hardship withdrawal is lower, Lester said.

In the aggregate, there was only a mild increase in 401(k) hardship withdrawals in 2007 across the 350 retirement plans studied, while three of the four Michigan plans saw a 75 percent increase in hardship withdrawals, and the rate of the withdrawals was about 50 percent higher than the national average.  

“Again, it’s a very small data set, so you have to take that with a grain of salt,” Lester cautioned.

In the Midwest region, the increase in hardship withdrawals was 14 percent in 2007, but in other regions, withdrawals did not increase: That suggests a shift in 401(k) withdrawals to the “hardship” classification in the Midwest compared to the rest of the country, Lester said. 

It might be very tempting to a person desperately seeking cash to cover an emergency to tap his 401(k), particularly when his retirement date is many years away, but Lester recommends that people who are considering a raid on their 401(k) should think long and hard about it. They should first talk to their retirement plan administrator or financial adviser so they can be advised about the consequences of withdrawing money from their 401(k) and its impact on their future savings for retirement, she said.

“It’s very, very difficult to pay those back, and you have to pay them back with after-tax rather than pre-tax dollars,” Lester observed.

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