A proposed law that attempts to protect key retirement savings would give employees who are laid off or fired more time to pay back early withdrawals from their 401(k) plans.
The bill is a “first step” in addressing an estimated $6.6 trillion shortfall in retirement savings for Americans, according to its sponsors. The 401(k) plan, funded by elective contributions by employees and employers, has become the principal retirement savings vehicle for U.S. workers. Assets held in 401(k)s grow tax free until withdrawn and can also be used to secured credit. The rate of borrowing against a 401(k) climbed to a record high of 28 percent during the Recession, according to Aon Hewitt.
Employees who are laid off, fired or find new employment are required to repay their 401(k) loans within 60 days of leaving their jobs. In times of financial hardship, participants commonly default on the repayments, suffer the ensuing tax penalties and deplete retirement savings.
“Our bill would allow for a greater period of time for the loan to be paid back thereby helping families pay back the loan and allowing the funds to be put back into their retirement savings and avoid the tax penalty,” said Sen. Mike Enzi, a Wyoming Republican who co-sponsored the bill known as the SEAL Act.
Taking a loan from a 401(k) plan can be a strategic financial move. By borrowing from and repaying themselves, participants can avoid high interest payments. Most participants eventually repay their loans in full and preserve their retirement nest egg. Problems arise when employees with outstanding loans leave their jobs, according to Aon Hewitt. Nearly 70 percent of ex-employees subsequently default on the repayment schedule, while active employees default on only 3 percent of loans.
The SEAL Act would also allow 401(k) participants to continue contribute to a 401(k) after making a hardship withdrawal. Current rules ban contributions for six months following the withdrawal.
“The loss of both employee contributions and company matching contributions during this period can exacerbate negative long-term effects on retirement savings,” states a press release issued by Enzi and the bill’s co-sponsor, Sen. Herb Kohl, a Democrat from Wisconsin.
The bill would place a limit of three on the number of loans participants can take at one time. The limit is designed to reduce the administrative burden and overall cost of the plan to workers, but in reality would affect only a tiny percentage of loans. Currently employers decide the number of outstanding loans employees can have on their 401(k)s, but AON Hewitt reports that more than two-thirds of employees – 68.3 percent – have one loan outstanding. Less than 30 percent have two and only 2.5 percent have two or more.
The SEAL Act would ban the 401(k) debit card, one of the products that “promote leakage” from retirement savings. The debit cards are not widely used, but some companies continue to market the products online, the senators’ release said. The legislation would not touch the current limits on 401(k) borrowing which cap withdrawals at 50 percent of the account balance to a limit of $50,000. The 401(k) must be repaid in five years, unless the withdrawal is used to buy a primary residence.
The SEAL Act – short for the “Savings Enhancement by Alleviating Leakage in 401(k) Savings Act of 2011 – adopts some of the recommendations contained in a 2009 report by the Government Accountability Office.