401k Loan Default Time Bomb Is Ticking

Posted on July 25, 2012 at 3:56 PM PDT by

One of the overlooked effects of the credit crisis has been the lengths to which otherwise prudent people were pushed to keep their heads above water. Unsurprisingly, a potentially huge 401k loan default time bomb is quietly ticking away.

By definition, a person who voluntarily builds up a 401k balance at work is saving on purpose for his or her own retirement. We go out of our way to encourage exactly this kind of behavior, with corporate matching contributions and tax breaks designed to help savers get the most out of each dollar they put away for the very long term.

401k Loan Default Time Bomb Is Ticking

Nevertheless, even prudent savers can get backed into a corner. A recent study shows that defaults on loans taken from 401k plans have skyrocketed, rising from a reported $665 million in 2007 to as high as $37 billion each year from mid-2008 to mid-2012.

That shocking number is from a study co-authored by Robert Litan at the Brookings Institution and Hal Singer, managing director at Navigant Economics. For comparison’s sake, $37 billion was the amount billionaire Warren Buffett promised in 2006 to the Gates Foundation. It was the bulk of his net worth at the time.

Litan and Singer figure up to 95% of 401k participants are in plans that allow for loans. Borrowing against a 401k balance is fraught with risks, they note, and often it happens because the saver has been turned down for traditional credit. Litan and Singer write:

Individuals with 401k plans borrow from them as a last resort because the loans are meant for retirement, not ongoing living expenses. Nonetheless, when times are tough — as they have been since the beginning of the Great Recession — many more people with 401k plans have no other choice but to borrow from their accounts to maintain even a reduced standard of living.

The cost of this kind of emergency borrowing is painful by design. The tax implications of borrowing and repaying a loan from your own 401k are supposed to be zero. Yet if the borrower gets laid off, the clock starts ticking: Pay it back in 60 days or default.

Once in default, things get ugly, as Litan and Singer explain. The borrower not only loses the portion of their retirement savings loaned but is required to pay taxes on the distribution and penalties on top of that.

The real risk of your 401k loan default

In comparison, about $8.1 billion in students loans are in default. Student loan default risks have been headline fodder for the past few months, and with good reason. High unemployment, particularly for freshly minted college grads, has been a hallmark of the recent recession.

Worse, student loan debt can’t be washed away in bankruptcy. Far too many young people took out unsubsidized private loans to get degrees that simply are not in demand.

But, as the retirement adage goes, your kids can borrow for their own futures. You, on the other hand, cannot borrow for your retirement. The huge, unspoken risk of such a large 401k loan default number is not so much that banks are in a deeper pickle than before. They aren’t. They didn’t loan out the money.

No, the problem is that large swathes of savers who tried very hard to put away even a little bit for their old age now find themselves wiped out or worse. They lose the positive effect of compounding, and they lose it forever.

There’s just no bull market big enough to erase bad choices on top of bad luck.