Loan defaults drain $37 billion from 401(k)s each year

According to the author of the article, a large number of Americans have been borrowing against their 401(k)s and have been having a difficult time paying the loans back. These loans are draining as much as $37 billion per year. Individuals have been borrowing this way usually because they don't qualify for traditional forms of credit.

By Blake Ellis
July 17, 2012: 5:32 PM ET
Gold IRAs

NEW YORK (CNNMoney) -- A large number of Americans are borrowing against their 401(k)s and having a hard time paying the loans back.

Defaults on 401(k) loans are draining retirement savings by as much as $37 billion a year, according to a study conducted by Robert Litan, a researcher at the Brookings Institution and Hal Singer, managing director of financial analysis firm Navigant Economics.

Based on historical default data and unemployment trends, the researchers project that the 401(k) default rate between July 2011 and May 2012 was 17.4% -- down from a projected peak of 19.8% two years earlier, but significantly higher than the documented 9.7% rate recorded in the 12-month period ending June 2008, right before the recession hit.

Many 401(k) participants are taking out loans against their retirement savings to cover emergency expenses, pay off debt or cover day-to-day costs -- often because they are unable to qualify for traditional forms of credit.

"When times are tough -- as they have been since the beginning of the Great Recession -- many more people with 401(k) plans have no other choice but to borrow from their accounts to maintain even a reduced standard of living," according to the study, which examined industry data on 401(k) default rates and outstanding loans.

Nearly all 401(k) plans allow participants to take out loans. Overall, about 18.5% of participants had 401(k) loans in 2011 -- up from 15% in 2006, according to the Investment Company Institute. And Americans borrowed a collective $105 billion from their 401(k)s in 2009, taking out an average loan of $7,860.

But thanks in large part to the economic downturn, many people have been unable to pay back their loans, often because of a job loss.

401(k) loan default rates tend to be directly correlated with the U.S. unemployment rate. When a participant with an outstanding 401(k) loan loses their job, the full loan comes due within 60 days. Many people fail to pay off the loan in time, forcing them to default. Other borrowers become disabled or die with balances remaining on their loans, the study found.

If you default on a 401(k) loan, the amount of the loan is deducted from the account, and you are charged income tax on the amount withdrawn. An additional penalty of 10% of the total loan amount is typically charged if the default occurs due to job loss. All of this money would otherwise be tucked away for retirement.

"This can take you from a $6,000 loan to a wipe-out of $10,000 from your 401(k savings) ... and this is happening to people at the very worse times of their personal and financial lives," said Singer.

The researchers recommend changing current rules so that participants who borrow are automatically enrolled in an insurance plan with an option to opt out, in order to protect them from losses incurred if they default on a 401(k) loan due to job loss.

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