July 19, 2008

Taking From Tomorrow to Pay for Today

By Fred O. Williams, The Buffalo News, N.Y.

Jul. 19--Yvette Thornton is caught in an unusual debt crunch.

The former Delphi worker, now retired, needs to make a $1,154 loan payment by September.

What's unusual is the identity of the lender -- herself. Thornton's own 401(k) retirement fund is the source of $30,000 she borrowed to help her ailing mother in 2004.

Even though she owes the money to herself, she'll be in trouble if she doesn't pay. Because she's younger than retirement age, the Lockport woman faces thousands of dollars in back taxes and penalties if she fails to scrape the payment together.

"I'll do my best to pay it back," the 52-year-old said. "I don't want the IRS to come to my door and audit me."

Borrowing from your retirement fund has been an easy way to underwrite big bills like home repairs, weddings and college tuition. But now the perils of borrowing from yourself are becoming apparent as the economy weakens, financial advisers say.

"This is a silent crisis that's out there," said John Lunghino, president of Spectrum Wealth Management, a financial consulting firm in Amherst. Thornton was one of hundreds of area residents he has counseled who face problems paying back loans from their retirement funds, he said.

People who borrowed from their 401(k) funds and then lost their jobs or took early retirement, like Thornton, face a double whammy:a depleted retirement nest egg, plus the specter of a 10 percent federal penalty on the unpaid portion of the loan.

"Younger families have taken the money out to pay for houses or cars," Lunghino said.

A 401(k) plan, named for a section of the tax code, is an employer- sponsored fund that allows savings to build up tax-free until retirement. About 40 percent of working-age families have access to a 401(k), and nearly three-quarters of the plans allow participants to borrow some of their savings before they retire.

The IRS said it doesn't have statistics on loan defaults, but the practice of borrowing 401(k) funds is booming. Borrowing rose to $30.8 billion by 2004, five times more than the amount taken out in 1989, according to a recent report from the Center for American Progress in Washington, D. C. The average loan was nearly $8,000.

The report, "Robbing Tomorrow to Pay for Today," concludes that retirement accounts are being raided to pay for rising medical bills, fuel and other costs. Eighteen percent of 401(k) participants have borrowed from their savings.

"For some people this means less leisurely living [in retirement], travel and so forth," said study author Christian E. Weller, a senior fellow at the center. "But for others it will mean not being able to pay for their prescription drugs."

The cost of borrowing is steep because of lost savings while the loan is repaid. Weller estimated that a $5,000 loan would reduce typical 401(k) savings by 13 to 22 percent.

So why are the loans popular? A big reason is that 401(k) savings are an easy source of cash -- especially as alternatives like home equity loans dry up. If their employer's plan permits borrowing, savers can take out half of their vested nest egg, to a maximum of $50,000. Rates are low, and, unlike bank loans, there's no credit approval process.

Some loans even come with a debit card so that you can tap retirement savings at the ATM -- a practice that came under fire this week. A measure to ban the debit cards was introduced after a hearing by the Senate Special Committee on Aging on Wednesday.

"After retreating over the last few years, companies looking to raid Americans' 401(k) accounts are making a comeback," said a statement from Sen. Charles E. Schumer, D-N. Y., a co-sponsor of the measure.

Amounts withdrawn before age 59z 3/4 ener 1/2 lly face a 10 percent federal penalty, in addition to deferred income taxes, although exceptions exist for people over age 55. The bite for someone like Thornton, if she can't avoid default, amounts to about 43 percent of the unpaid loan, Lunghino estimated. That would be more than $7,500, based on the remaining loan balance of $18,000.

The penalty is designed to encourage people to preserve their savings until their later years. But Thornton said necessity caused her to take the money out early. When her mother became ill, Thornton took time off from work to care for her and helped pay her expenses, including a car loan. Then Thornton retired early from Delphi in 2006 because the company had filed bankruptcy, raising fears that its plant might close. When an early retirement offer came around, the time seemed right.

"Every single day while we were at work, people were freaking out," she said.

In Western New York, financial planners say they counsel against 401(k) borrowing, putting the brakes on the practice. Still, it affects many.

More than half of Joseph Curatolo's clients let their 401(k) loans default if they still owe payments when they hit retirement, he said. They usually take advantage of an exemption that waives the 10 percent penalty for people over 55 who are out of a job.

"Rather than have to keep making payments in retirement, they'll default," said Curatolo, president of Georgetown Capital Group in Williamsville. However, they still have to pay the deferred taxes on the amount withdrawn earlier, leaving less cash for their retirement.

Others trying to avoid default may work out installment payments that provide more time to make good on the loan, financial advisers said. Borrowers from some plans can make a payment once every 90 days to avert default, rather than once a month.

At L&M Financial Services in Amherst, President Gregg Lipsitz is seeing a similar push from people to tap savings from their Individual Retirement Accounts. Like 401(k) plans, IRAs allow savings to accumulate tax-free until retirement. Lipsitz said he's helping more and more clients set up early withdrawals from their IRAs as they retire early. If you're no longer working, the complex "72T" distribution process avoids the 10 percent penalty for amounts withdrawn before age 59z.

"It's a very last resort," Lipsitz said. "But times are tough -- people are looking to pay their bills."

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