As the housing market has deteriorated, some observers expected to see a slowdown in consumer spending, since mortgage equity withdrawals have provided a boost in a period of stagnant real wages for average workers (last year, an exception to a longstanding trend, saw a wee pickup).
But defying this logic, consumer spending has continued to be fairly robust. What gives?
It turns out that there are signs that consumers are raiding a different piggybank, namely, their retirement accounts. And while 401(k) plans do permit borrowing, most advisers recommend against it, since the interest isn’t tax advantaged and failure to repay results in nasty penalties.
It’s too early to tell if the increase in 401(k) borrowings and redemptions is a small uptick or the beginning of a sustained, and therefore more troubling trend.
From the Wall Street Journal:
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.
“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.
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….
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.
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.”
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I doubt people are borrowing from 401k’s for whimsy purchases. I would suspect that if they are doing so, it is to meet mortgage or medical payments.
I was out of work a few years ago for nearly 18 months and had to tap into my IRA to the tune of nearly 25k. I couldn’t pay the taxes when they came due (after two extensions) and had to go on an IRS payment plan. I was employed again by that time but it took me another year to pay the IRS off. With penalties, I think the bill was nearly 6k. Not good.
Tapping a 401K early is usually a loosing proposition. But consider the following: If you make above the $90K limit for social security, any withdrawal is not going to get that additional tax of 6%, just the 10% penalty and the standard income tax rate. So that’s only 4% plus the differential between present income tax rate and the anticipated future tax rate. The general assumption is that the tax rate in retirement will be lower due to the progressively lower tax rates on lower income. But tax rates right now are quite low and the huge deficits portend higher future tax rates across the board. This means that there might be a case for those in the $90K to low $100Kish range to cash out now, or at least that the hit won’t as bad as it might first appear to be.
Another problem is that many 401K plans have limited or poor choices, low yields, and non existent oversight (MBS funds anyone?). On top of that, if you happen to think that the equity markets have become something between a large casino and a ponsi scheme, it might prompt one to want to exit the market. If you think that the market is going to tank, or that inflation is going to erase it’s value, why not cash out and invest it in some tangible asset or income producing investment? When your money is in a 401K you really have little flexibility.
Another quirk is employer matches. If you have a large match like 50 cents on the dollar, it might make sense to max it out and cash it out at vesting. It would almost be like putting some of your pay in short term, high yield (and high fee) paper.
I haven’t done any of the above, but they seem like interesting spreadsheet exercises.