As times get tough, at least some employees are likely to turn to their 401(k) plan balances for funds to keep going—if they haven’t done so already. A survey of 245 large employers conducted by Watson Wyatt Worldwide in February 2009 found that 45 percent of companies are seeing more 401(k) plan loan activity, up from 19 percent in October 2008 and 27 percent in December 2008.
However, plan loans are not necessarily a drawback to long-term savings because participants must repay the loans with interest. If a participant defaults on a loan, however, the defaulted amount is subject to income taxes and early withdrawal penalties.
In a more troubling development, the survey found that 35 percent of the companies surveyed had seen an increase in hardship withdrawals from 401(k) plans, more than double the percentage of companies that reported such withdrawals in October 2008 and December 2008.
If this pattern holds true for the broader participant population, it could have repercussions. Participants who take hardship withdrawals when financial markets are at their nadir are pulling money out at exactly the wrong time.
Moreover, these withdrawals can be painful to long-term retirement savings because they are subject to both income tax and—for those who have not yet reached 59½ years of age—a 10 percent penalty. A participant under 59½ and in the 28 percent federal tax bracket who withdraws $100 from a 401(k) plan would walk away with only $62 after taxes: $100 minus $28 in income tax and minus a $10 withdrawal penalty.
Internal Revenue Service regulations allow 401(k) participants to make hardship withdrawals only under certain conditions: to pay for certain medical expenses; to buy a principal residence; to pay tuition or other educational expenses; to prevent eviction from, or foreclosure on, a principal residence; to pay for burial or funeral expenses; and to cover certain expenses for the repair of the employee’s principal residence.
Regulations do not require a specific reason to qualify for a plan loan.