Well over half of U.S. employers use 401(k)s and other defined contribution plans to encourage their employees to save for retirement, collectively spending more than $118 billion in match contributions and encouraging employees to save another $175 billion every year, according to a January 2013 report, The Retirement Breach in Defined Contribution Plans: Size, Causes and Solutions.
Yet, more than 25 percent of households that use a defined contribution plan for retirement savings have withdrawn, or breached, some or all of their plan balance for nonretirement spending needs, amounting to more than $70 billion withdrawn in 2010, the most recent year for which the relevant Federal Reserve and IRS data were available, according to the report by analysts at financial advisory firm HelloWallet.
Of that breached $70 billion, nearly $60 billion was subject to income taxes and IRS early-withdrawal penalties, while the other $10 billion included new loan originations that risk being taxed and penalized if not eventually repaid.
In general, when employees take a distribution from a traditional 401(k) or other non-Roth defined contribution plan before age 59½, they are subject to a 10 percent penalty in addition to owing income taxes on the amount withdrawn (see "Loans vs. Hardship Withdrawals," below).
Moreover, the value of penalized breaches has increased over time, growing from about $36 billion in 2004 to nearly $60 billion in 2010, according to the report, which also noted that:
By the time workers hit their 40s they are highly likely to be burdened with mortgages and revolving credit card debt and have children in high school or on their way to college, creating the largest pressure to breach among any age group.
• Workers in their 40s were most likely to breach their savings for nonretirement needs.
• More than 70 percent said they breached their account because of basic money-management problems. Similarly, workers were up to six times more likely to have taken out a loan from their plan if they did not have sufficient emergency savings, while fewer than 8 percent of breachers said they took early distributions because they had been laid off.
Stemming the Breach
"The evidence provides guidance about how plans can proactively take steps to reduce breaching in their population," the HelloWallet report concludes. Among the recommendations:
• Teach household budgeting. "As a basic first step, helping workers better manage their finances by reducing the prevalence of spending more than they make and to meet their monthly recurring expenses could reduce the prevalence of breaching," the authors advise.
• Urge setting aside emergency funds. "Encouraging workers to save for emergencies prior to using their retirement savings program would potentially reduce the need to breach and both strengthen the integrity of a retirement plan and the sustainability of its assets over a worker's lifetime," the authors note.
However, the report advises against further prohibiting distribution options for participants. "Nearly all households that breach are financially unhealthy even after they receive distributions from their retirement savings," the authors point out. Prohibiting access to retirement funds, in these cases, would "exacerbate the basic money-management problems that are strongly associated with breaching in the first place."
Loans vs. Hardship Withdrawals
401(k) plans may (but are not required to) allow participants to take loans or make hardship withdrawals.
Loans must be paid back over five years, although this can be extended for a home purchase. While loan interest rates vary by plan, the rate most often used is the "prime rate" plus 1 or 2 percentage points. Interest is paid back into the participant's 401(k) account. If not repaid within five years, the loan amount is treated as a distribution and if participants are not at least 59½ years old, they must pay a 10 percent penalty on top of income taxes on the withdrawn funds.
Hardship withdrawals are subject to certain IRS restrictions. The withdrawn amount is subject to income tax and, if participants are not at least 59½ years old, the 10 percent withdrawal penalty, unless certain exceptions apply. Participants do not pay back the withdrawn amount, which means their ultimate retirement savings will be much more seriously affected than with a loan.
Another View on 401(k) Loans
Participants’ 401(k) loan balances increased slightly in 2011, according to a December 2012 report by the nonprofit Employee Benefit Research Institute (EBRI).
At year-end 2011, 21 percent of all 401(k) participants who were eligible for loans had loans outstanding against their 401(k) accounts, unchanged from year-end 2009 and year-end 2010, and up from 18 percent at year-end 2008.
Loans outstanding amounted to 14 percent of the remaining account balance, on average, at year-end 2011, unchanged from year-end 2010. Loan amounts outstanding increased slightly from those at year-end 2010.
Stephen Miller is an online editor/manager for SHRM.
Loans: A Balancing Act, HR Magazine, January 2013
Generation X Most Concerned About Financing Retirement, SHRM Online Benefits, October 2012
‘Plug the Drain’ on 401(k) Plan Leakage, SHRM Online Benefits, August 2011
SHRM Online Benefits Page
SHRM Online Retirement Plans Resource Page