At the same time, participants in 401(k) plans have been taking out more loans against their accounts since the start of the financial crisis, according to one recent industry study.
At the same time, participants in 401(k) plans have been taking out more loans against their accounts since the start of the financial crisis, according to one recent industry study.
"The amount of loans outstanding in 401(k) plans has risen significantly over the past five years and paints a very sobering picture of America's capacity to save for retirement," says Rob Austin, director of retirement research at human-resources consulting group AON AON -1.13% Hewitt.
In U.S. 401(k)s and related accounts, one out of every four plan participants has borrowed against his or her principal, according to the group's latest research.
Meanwhile, an estimated $6 billion a year in loans wind up in default, finds a new study published by the Wharton School of the University of Pennsylvania.
The vast majority do pay off their loans, says Jean Young, a co-author of the report and a senior research analyst at the Vanguard Center for Retirement Research in Valley Forge,VLYFQ -14.29% Pa.
But those making less than $30,000 a year are most likely to get into situations where they need to take out a loan, Ms. Young says. "These are also the employees who are least likely to contribute to their workplace retirement plans," she adds.
Financial advisers typically target more affluent investors. It's not surprising then that much of the 401(k) borrowing activity probably takes place without much in the way of outside expertise, says Mr. Austin of AON Hewitt.
"Our research leads us to believe that 401(k) plan participants are looking for more financial help, and that they tend to make better decisions by seeking out independent advice," he says.
Last year alone, adviser James Sampson says he talked to more than 100 different investors about taking out 401(k) loans. He focuses on helping companies run retirement plans at Cornerstone Retirement Advisors in Warwick, R.I., with $200 million in assets.
His responsibilities include working with plan participants, both executives and rank-and-file employees. In most cases, Mr. Sampson says he recommends 401(k) loans only in the most dire of circumstances.
In some cases, particularly when credit-card debt builds and comes with double-digit interest rates, he says that borrowing from a retirement plan at much lower rates can make sense.
Mr. Sampson also tells investors that 401(k) loans act much like a slow-growth bond investment since loan amounts taken out are usually repaid at fairly low rates of interest.
During stock market uptrends, pulling money out of a retirement plan's long-term oriented investment portfolio can prove counterproductive as well, he says.
"People think about 401(k) loans as free money, but the opportunity costs can be enormous over time," Mr. Sampson says.
If a loan goes into default, the amount still owed is likely to be considered as taxable income for that particular year, notes Marilyn Plum, director of portfolio management at Ballou Plum Wealth Advisors in Lafayette, Calif., with $270 million in assets.
"It's important to let people know that they risk kissing any chance for a tax refund at the end of the year goodbye if they take out a 401(k) loan and can't pay it off," Ms. Plum says.
A 401(k) loan default usually occurs after the investor leaves his or her job and fails to repay the loan in full--normally within 30 to 90 days, according to advisers.
Investors who default in most cases have to pay federal and state income taxes. Those under age 59 1/2 who default also are likely to be hit with a 10% early-withdrawl penalty.
But the ease of taking out a loan at work as compared with using a traditional bank can be very tempting, says Chad Carlson, an adviser at Balasa Dinverno Foltz in Itasca, Ill., with $2.7 billion in assets. "We see a lot of repeat offenders who treat 401(k) accounts almost like their own personal piggy banks," he says.
In most cases, better ways can be found to overcome mounting debt, suggests Michael Gouldin, chief executive at Gouldin & McCarthy in Basking Ridge, N.J., with $400 million in assets.
Planning ahead and doing proper due diligence is the key, he says. Still, Mr. Gouldin estimates that only about 10% of the investors his firm works with through individual accounts and serving as an adviser for 401(k) plans actually ask before taking out a workplace loan.
"By the time it reaches that point, they don't want to hear someone tell them not to do it," he says.
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