Raiding Your 401(k) to Pay the Bills

More people are dipping into their 401(k) retirement accounts to get by. Wall Street Journal personal finance columnist Jonathan Clements explores who's doing it and the risks they're taking.

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RACHEL MARTIN, host:

Okay. So we here at THE BRYANT PARK PROJECT are not going to be the first to use the r-word - recession. But let's face it, with the mortgage crisis, a sluggish stock market, sagging U.S. dollar, these are not the rosiest of economic times. And that has some people dipping into their retirement savings, 401(k)s to be exact, which have pretty much replaced pensions as the retirement instrument of choice in the U.S.

A couple of retirement fund managers are reporting double-digit increases in loans and early withdrawals from 401(k) accounts over the past year. But is borrowing from your future the best way to get through economic tough times today?

Joining us now to talk about those consequences is Jonathan Clements. He is a personal finance columnist for The Wall Street Journal.

Hi, Jonathan.

Mr. JONATHAN CLEMENTS (Finance Columnist, The Wall Street Journal): Hi, Rachel. It's great to be with you.

MARTIN: Thanks for being on. Hey, Jonathan, how many people are actually doing this, tapping into their 401(k)s?

Mr. CLEMENTS: We don't really know for sure. I mean, historically, something like 18 percent of 401(k) participants borrow against their loan balances. Meanwhile hardship withdrawal, the other way that you can get your 401(k) money, among those who are under aged 60, it's typically only one or two percent, but it's anecdotal evidence that we've seen a spike in both these areas. For instance, one of my sources told me that we've seen a big increase in hardship withdrawals in places like California and Michigan where, of course, you know, that's, you know, ground zero for the subprime mortgage crisis.

MARTIN: What do you have to prove in order to get a hardship withdrawal?

Mr. CLEMENTS: Well, the hardship withdrawal, the IRS has various sort of criteria. You know, you need to have high medical expenses. You need to be facing foreclosure. Maybe you're buying a home. But even if you meet these criteria, you then have to look at the rules to your particular plan because the plan may not allow hardship withdrawal and they may have slightly differently set of rules.

But what people should understand about hardship withdrawals is the real hardship is the price you're going to pay because if you go in and you tap that 401(k), you take money out, you're going to hit with income taxes. You're probably going to get hit with some sort of tax penalty. And then you get hit with state income taxes. Say you're in the 25 percent income tax bracket, you pull a door out of your 401(k) for a hardship withdrawal, you may end up giving 40 cents out of that dollar back to the tax man.

MARTIN: Wow, so maybe not worth it in the long run. These 401(k)s were originally designed as a way to encourage people to invest in their own retirement, to take ownership of that process. Were there conversations at the time - did anyone ever expect that this would happen? That people would take advantage of them in this way, this frequently?

Mr. CLEMENTS: Well, actually one of the interesting things about the way 401(k) plans were designed was the notion was that if you give people the sense that they have access to the money, that maybe they would be more likely to contribute. So loan features where you can go and you can borrow up to $50,000 from your 401(k), that sort of loan feature is attractive. People say, I don't want to put my money in the 401(k), you know, the employer will say, well, but you could always borrow the money, and they'll say, okay, I'll put money in. And the hope, of course, was that people wouldn't use that loan feature. Well, guess what? They are.

MARTIN: They are.

Mr. CLEMENTS: And the problem is when you borrow from the 401(k), you have to pay that money back with interest. People say, well, that's attractive. But the problem is the money has come out of that 401(k) which means that it's not earning investments gains, so you're going to end up with less money at retirement. Moreover, if you leave your employer, say you're going to get another job, that 401(k) loan become immediately payable. And if you can't come up with the cash, then the money is considered to have been distributed and you'll pay income taxes and tax penalties.

MARTIN: Is there any evidence that people take the money out and maybe in a couple weeks - maybe they just need a short-term fix, that they are then repaying it and replenishing the 401(k)s?

Mr. CLEMENTS: You know, it's hard to know how this sort of plays out. But normally these loans are not set up as short-term loans. Typically, there's some sort of fixed repayment schedule. Either you're paying back over, say, a five-year period. So these are not designed to be short-term fixes, and the plan administrators are not really going to allow you to do that sort of thing.

MARTIN: Considering the current state of the economy, Jonathan, is this kind of understandable, or is this something particular about American culture that doesn't encourage long-term planning.

Mr. CLEMENTS: Well, I think there are a couple of different things going on. One is I think generally we find it very difficult to think long-term. I mean, it all goes back to evolutionary psychology, you know, our caveman and cavewoman great, great, great-grandparents, you know, they were just thinking about getting through tomorrow; they weren't worried about retiring in 40 years. In terms of the way we think, we're just not built to think long-term.

But also because of the long prosperity that we've enjoyed here in the states -I mean, let's face it, it's been a lot of years since the Great Depression, people have become very comfortable taking financial risk. We saw that in the early part of this decade. People were happily borrowing against the value of their home. We saw booming amounts of home equity lines of credits as people took money out of their home and spent it on other stuff, that of course has been tapped out, so people are looking around and saying, okay, can't tap my home anymore so what am I going to tap next? Well, just about the only game left in town is the 401(k) so now people seem to be turning to that.

MARTIN: Let's talk about that, the shift away from pensions over the past 30 years, 401(k)s seem to be the instrument of choice. Has that on balance been a good thing for workers?

Mr. CLEMENTS: I would argue that it hasn't. I mean, being in favor of corporate paternalism is probably not a popular stance to make, but the reality is people did not seem to be very savvy about managing their 401(k) plans. In fact, if you go back to the 1990s, the sort of model for 401(k) plans was you give people a lot of investment choices, you give them some educational materials, and they'll make good choices. Well, guess what? They didn't.

MARTIN: We don't. Oh, no.

(Soundbite of laughter)

Mr. CLEMENTS: So now we're actually heading in the other direction and people are saying, okay, let's cut down on the number of choices we give in 401(k) plans, maybe we'll bring in more advice, maybe we'll instead just offer this limited selection of what are called retirement funds which essentially give you one-stop investment shopping. The notion now is let's limit the choice that people can make, let's guide their choices and hope they are smarter about the way they use these plans.

MARTIN: So let's get back to this phenomenon right now that's affecting us. The current economic crunch has people dipping in to these 401(k) plans. We've already defined the fact that this is not a good idea: stealing from your future, long-term implications. What should people be doing instead if they say, listen, I can't think about the future right now 'cause I can't pay my mortgage?

Mr. CLEMENTS: Well, clearly, if you don't have any other choice, you don't have any other choice. But if you have some sort of other option, you really should look at it. One of the traps that I think a lot of people get into is they look at the size of their paycheck, and they say, all right, what can I cover out of this paycheck? And so they start taking on all these monthly obligations. They take on the big mortgage. They take on the car lease. They get the expensive cable package. They got the cell phone. They got the satellite radio. All of these monthly obligations, and suddenly they have very little financial leeway. So one of the things that I would think about doing, if you're finding that you're strapped for cash every month, is to go back and look at those monthly obligations. And see if you can give yourself a little bit more financial breathing room by either reducing or getting rid of some of these monthly obligations.

MARTIN: Change your lifestyle a little bit it sounds like. You might have to ditch that cable.

Mr. CLEMENTS: And the satellite radio, you don't want to have that anyway.

ALISON STEWART, host:

No, we do.

MARTIN: We're on satellite radio.

STEWART: We love satellite radio. Bite your tongue.

MARTIN: Jonathan Clements, personal finance columnist for the Wall Street Journal. Hey, thanks, Jonathan, we appreciate it.

Mr. CLEMENTS: My pleasure.

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