Workers step up raids on 401(k)s

Defined-contribution plans such as 401(k)s held roughly $4.4 trillion at the end of June. Most 401(k) plans allow participants to take out loans, and generally workers can borrow the lesser of $50,000 or 50% of their account balance. Among participants with loans, the average unpaid balance at the end of 2006 was nearly $7,300, according to the Employee Benefit Research Institute. Loans aren't taxed, but participants repay the loans, plus interest, with after-tax dollars. Though interest rates vary from plan to plan, a typical rate is the prime rate -- currently 6% -- plus 1%. General-purpose loans must be repaid within five years.

Some workers raid their 401(k)s without fully understanding the consequences. Joanna Bare, 40, of Bethesda, Md., took a $35,000 loan from her 401(k) in 2005 to cover a huge tax bill resulting from the sale of stock she had held since she was a child. But she hadn't realized she would need to repay the loan with after-tax dollars even though the 401(k) account was funded with pretax savings, meaning the loan repayments would take a bigger bite out of her paychecks than she had anticipated.

While repaying the loan, Bare had to drop her monthly 401(k) contribution to $200, from about $900 previously. "I used every scrap of income I could find to pay it off," she says.

Possible fees and taxes

Things get really ugly when 401(k) borrowers lose or change their jobs. In that case, the borrower must repay the entire outstanding loan balance right away. If the borrower can't pay off the loan, he'll owe income tax on the unpaid balance and, typically, a 10% penalty if he's under age 59½. Such a scenario may be a particular concern at a time when the economy is slowing and layoffs may become more common, says Rick Brooks, a financial planner in Solana Beach, Calif.

Workers taking loans also miss out on market returns on the money they've borrowed. A borrower may wind up paying himself less interest than his money would have earned if it had remained invested in his 401(k) plan.

Consider this example from T. Rowe Price: A participant with a $20,000 account balance who contributes $100 a month and earns an annual return of 10% would have $624,681 after 30 years. But if that participant borrows $10,000 from his plan and repays the loan at 7% interest over five years, halting contributions while he repays the loan but making $100 monthly contributions for the next 25 years, he would have only $523,502 at the end of the 30 years.

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If participants decide they must take out 401(k) loans, they should aim to pay them off as quickly as possible and continue making new plan contributions while paying off the loan, taking full advantage of any employer-matching contributions. "As long as you keep contributing, the long-term negative impact isn't nearly as significant," says Pamela Hess, the director of retirement research at consulting firm Hewitt Associates.

The 401(k) loans are increasing despite some employers' efforts to discourage them. More plans are adding fees on loans or limiting the number of loans that participants can take, aiming to deter excessive borrowing, Hess says. Nearly 80% of plans charged loan-origination fees in 2007, up from 63% in 2001, and the average fee was $55, according to Hewitt.

Some plans also charge annual loan-servicing fees, and many plan providers educate participants about the potential pitfalls of taking loans. "We don't endorse taking out a loan from a retirement savings plan," Fidelity spokeswoman Jennifer Engle says. "It's a funding source of last resort."

This article was reported and written by Eleanor Laise and Craig Karmin for The Wall Street Journal.

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