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Warn employees of the dangers of dipping into 401(k) funds

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in Compensation and Benefits,Employee Benefits Program,Firing,HR Management,Human Resources

As the economic meltdown worsens, employees facing personal budget crises may go looking for their own financial bailouts—by tapping into 401(k) savings. They may turn to HR pros like you to learn how to take hardship withdrawals of 401(k) funds or borrow against their investments.

There are good reasons to steer them away from treating their retirement nest eggs as rainy-day funds.

With personal savings rates near an all-time low, many Americans believe their 401(k)s are all they have to fall back on. “Because the credit crisis has made borrowing from financial institutions more difficult, we’re seeing more employees turn to their 401(k)s to get the money they need to help them get by,” says Pamela Hess, director of retirement research for the HR consulting firm Hewitt Associates.

But 401(k) funds continue to take huge hits as the stock market tanks. Analyses of 401(k) performance by three of the biggest investment firms—Fidelity, Vanguard and T. Rowe Price—found that the average 401(k) lost 27.5% of its value in 2008.

Hewitt Associates reports that more than 6% of employees withdrew money from their 401(k)s in 2008, up from 5.4% in 2007. Fueling the upsurge was a 16% increase in hardship withdrawals.

The IRS strictly limits when employees can withdraw funds from 401(k)s—to pay medical bills, stave off foreclosure and avoid bankruptcy, for example. But it imposes stiff taxes, penalties and interest payments to discourage raiding of retirement funds.

Advice: If employees ask how to withdraw from 401(k)s, refer them straight to the investment firm that manages your plan. It’s not appropriate for HR professionals to counsel employees about taking such a drastic step—and doing so could create liability for you and your organization.

Communicate the downside

HR can, however, help employees understand the downside of 401(k) loans.

While only about 2% of employees opt for hardship withdrawals, 22% of 401(k) participants have taken out loans against their savings.

According to the Employee Benefit Research Institute, about half of 401(k) plans allows employees to take out loans against their 401(k) retirement funds to pay urgent expenses. It’s almost always a bad idea.

“Sometimes loans are inevitable in the face of severe financial pressures, such as paying medical bills or bridging the gap if a spouse loses his or her job,” says Valerie Gieseke, a benefits communication consultant with the benefits administration firm TRI-AD.

Nonetheless, she urges HR pros to take the lead in informing employees why 401(k) loans should be a last resort.(Again, it’s not your role to be a financial advisor; you’re merely providing information).

4 reasons not to tap 401(k)s

1. It’s not “free” money. When employees take loans against their 401(k) balances, they must repay them—with interest—usually within five years. A common interest rate is the prime rate plus 1%. Most plans charge a loan origination fee that can top $150.

2. Loan payments will be taxed twice. While normal 401(k) contributions come out of employee paychecks on a pretax basis, loan repayments come out of take-home pay. Then employees will pay taxes again in retirement, as they withdraw funds to live on.

3. Long-term returns will decline. When employees pull money out of their retirement funds, those dollars are no longer growing through interest compounding. That’s less money to retire on.

Note: Many 401(k) borrowers slow down or stop making contributions while repaying their loans. That double-whammy severely shrinks the bottom line of funds available for retirement.

4. Terminated employees are on the hook for the entire loan balance—and maybe taxes, plus penalties. Some plans let employees continue to make payments after termination, but others call the note right away. In either case, if an employee fails to pay, the IRS will consider the loan in default. That turns the loan into a distribution, which is taxable and subject to a 10% early-withdrawal penalty.

In times like these—when the threat of layoffs looms and nervous employees may want to change jobs—this should be a top-of-mind consideration.

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