The future that is America

by on January 17, 2013 at 7:33 am in Current Affairs, Economics, Uncategorized | Permalink

A large and growing share of American workers are tapping their retirement savings accounts for non-retirement needs, new data show.

The withdrawals, cash-outs and loans are draining nearly a quarter of the $293 billion that workers and employers deposit into their 401(k) and other savings accounts each year, undermining already shaky retirement security for millions of Americans.

Is this because standards of living have been going up so much (free Facebook), or because some individuals, rightly or wrongly, feel compelled to make up for stagnant or declining job market prospects?  You tell me, here is more on that one.  I call it the tyranny of consumption smoothing, an underreported theme in welfare economics.  And there is this:

Fresh data from Vanguard, one of the nation’s largest 401(k) managers, show a 12 percent increase in the number of workers who took loans against their retirement accounts or withdrew money outright since 2008.

The most common way Americans tap their retirement funds is through loans, which must be repaid with interest. Those who withdraw money face hefty penalties. In most cases, they not only incur a 10 percent federal tax penalty but also pay capital gains taxes.

And from the NYT, this article considers how the feeling of scarcity drives the desire to borrow.  These points are related to income inequality, and here you will find my colleague Garett Jones on whether individuals with low time preference will inherit the earth (pdf).

Ari Spectorman January 17, 2013 at 7:41 am

Embarrassing error: withdrawals from 401(k)s and any other retirement account face ordinary income taxes, not capital gains taxes. (Plus the 10% penalty.)

anon January 17, 2013 at 9:08 am

incur a 10 percent federal tax penalty

Only if you are younger than 59 1/2.

Andrew' January 17, 2013 at 9:29 am

I love how there is a half, as if to say “F U marginalism!”

mulp January 17, 2013 at 12:38 pm

Yes, the error is severe because many making the withdrawal were punished by paying income taxes on capital gains without the benefits of the capital gains exemption!

If you have lost property or faced health problems or due to job loss needed money for education, then you are generally exempt from the 10% penalty under the various exemptions added, but if you were lucky to have survived the crash and had high returns from capital gains, or dividends, the deal on tax deferral is withdrawals become regular income, and if you withdraw substantial amounts, the tax rates will be higher than the cap gains cap.

But note that while the tens of millions with money invested in the stock market which has shifted over the past 30-40 years from dividends to stock price gains, the screaming about the higher capital gains cap would make you believe the tens of millions of people with their retirement savings are going to b crushed by higher taxes, taxes they never get to use based on 40x(x) and IRA tax law.

Tax law is distorted by Wall Street to promote pump and dump asset churn which siphons savings from workers into the pockets of Wall Street traders. Churn those assets in your IRA to benefit from low capital gains rates before Obama hikes the capital gains rates!

jebaldwin January 17, 2013 at 7:51 am

I’m guessing that long term unemployment is playing a role in the increased withdrawals, just to meet living and/or relocation expenses…not to mention small business owners propping up various ventures whose revenues are still down from ’08.

Tim January 17, 2013 at 4:34 pm

My hunch is that paying college tuition is an issue as well.

Peter Schaeffer January 17, 2013 at 8:38 pm

My guess is that this is just a continuance of MEW (Mortgage Equity Withdrawal). Since the MEW window is mostly closed, households are stripping equity from retirement savings. One way or another, a significant fraction of the population is committed to spending more than they earn. Part of this is no doubt hardship driven. However, at the peak of the MEW bubble, home equity consumption (conversion to spending) was largely a middle to upper-middle class phenomenon. It did not appear to be largely driven by job losses, unexpected household expenses, etc. More of a vacation, credit cards, and granite counter tops theme.

This time around, things might be different. But they might not be as well.

Bill Harshaw January 17, 2013 at 7:53 am

Making mortgage payments? IMHO it might be rational to do so, assuming housing prices are going to rebound before retirement.

Tom Murin January 17, 2013 at 8:30 am

You pay the interest to yourself. I used a loan to payoff an auto loan where I paid the interest to a credit union. There are rational ways to use these loans.

Nicoli January 17, 2013 at 9:35 am

“The most common way Americans tap their retirement funds is through loans, which must be repaid with interest.”

The loan interest rate for the TSP (401k for government employees) was down to as low as 1.25% late last year and is 1.5% now. That is far cheaper than the 6.8% or higher for many student loans or much higher for many private loans especially credit cards. Seems like a perfectly rational decision to me. The early withdrawals is troubling but with relatively weak returns from equities, this last year was an exception, I can understand people using cheap money to rid themselves of debt.

Brian Donohue January 17, 2013 at 1:17 pm

But you pay the interest to yourself, so whatever rate you charge nets out to zero. All a higher interest rate does is increase the element of ‘forced saving’ in the repayment- it’s just a cash flow squeeze.

Nicoli January 17, 2013 at 1:46 pm

That’s a good point. The cash flow issue is a real one though. If you are looking to qualify for a mortgage etc. your repayment can still be counted against your ability to repay a loan.

john personna January 17, 2013 at 10:44 am

You repay a loan to yourself, out of cash flow, generating opportunity costs. I’d love a study to see how loans impact future savings rates. My money is on a serious downward pressure.

Dan Weber January 17, 2013 at 4:46 pm

You also have to repay the entire balance immediately if you leave your job.

Which may be a fine risk if you can switch another debt into a loan to yourself. Just watch out.

Benny Lava January 17, 2013 at 8:36 am

Why does Tyler assume this is to boost personal consumption? And would he classify paying medical bills or children’s college tuition as “consumption”? I guess I have to be the first to point out that wages are declining so it isn’t a surprise.

Norman Pfyster January 17, 2013 at 9:21 am

“And would he classify paying medical bills or children’s college tuition as “consumption”? ”

Yes. HTH.

MG January 17, 2013 at 8:52 am

Thanks for the link to Prof Jones’ paper on IQ and time preferences. As to your final comment of “whether individuals with…”, I would note that the paper’s claim (at least as far as the abstract purports) appears to (wisely) confine the benefits to “countries”. My experience with progressive Western democracies suggests that the degree to which “individuals” who possess these traits can expect to reliably and significantly outperform the mean will be smaller than expected, as those who do not possess these traits can be counted on to see a need for some serious redistribution. By the time everything is said and done, a lot of the inequality that would have been driven by IQ and patience will be squashed, intermediated by those endowed with political IQ and the impatience that Public Choice, not any Growth theory, predicts.

Andrew' January 17, 2013 at 8:52 am

Sooooo…there wasn’t any way to let people spend during the depression and then encourage them to catchup after?

ladderff January 17, 2013 at 8:58 am

Tyler calls it the tyranny of consumption smoothing. Seems plausible to me, but there is another possibility: the tyranny of “burn em while you got em.” Call it anti-Ricardian Equivalence. With the entire Western world gearing up for a big game of beggar-thy-neighbor, better set yourself up to be a beggar than a neighbor. I doubt that people like Tyler have actually failed to consider this possibility; they just don’t see much point in talking about it.

Benny: Tuition and medical bills are both consumption.

anon January 17, 2013 at 9:11 am

+1

If a person believes we will see hyperinflation in the next 10 to 15 years, they may be withdrawing money from Vanguard and other funds to put it into various hard assets.

msgkings January 17, 2013 at 1:49 pm

Then those people are pretty dumb, because you can buy plenty of hard asset funds at Vanguard without paying the taxes and penalties on withdrawals.

Now, if you’re actually thinking about the total collapse scenario, where you need actual gold bars and lots of guns and canned food….good luck with that.

Dick King January 17, 2013 at 9:02 am

This can be a rational response to the current meme of means-testing social security. People who have too much in their 401K’s will have their social security reduced, so spending your 401K may cost less in terms of retirement living standard than you might otherwise predict.

-dk

BC January 18, 2013 at 7:05 am

It’s not means-testing specifically, but any sort of redistribution built into old-age entitlements which, of course, there already is in Social Security even without means testing. (Higher income contributors receive less benefit per marginal dollar contributed to subsidize low-income contributors.) The disincentive to save arises from lack of credibility that promised future benefits can actually be paid, that the principle used to resolve any shortfall will be to tax the “wealthy”, and that people that have “too much” in their 401(k)’s will be deemed “wealthy” so that their “excess savings” will be used to fund others’ retirements rather than their own. The wealth transfer could come in the form of means-testing, but could also come in the form of changing the tax treatment of 401(k)’s in some way. Perversely, disincentives to save increase the number of people dependent on Social Security, thus making reform even more difficult, thus adding to the “wealth redistribution risk” of saving.

So, we have a wealth-effect and a substitution-effect explanation for reduced 401(k) savings. Thought experiment: if we were to reduce future Social Security (and for that matter Medicare) benefits for working-age people now by a sufficiently large amount that no one doubted that those future reduced benefits could be paid, that would decrease the wealth of current workers by the present value of the reduction in benefits as well as removing the redistribution risk of saving. Would current workers save less in their 401(k)s due to the wealth effect or would they save more to substitute for reduced future benefits? The idea that they would save less because they would be less wealthy and the poor save less seems unlikely.

Miley Cyrax January 17, 2013 at 9:16 am

At current trends, globally those with a higher time preference are more wont to exercise the option to have offspring earlier and more often. Those with high time preferences will inherit the earth by volume, even if their more patient peers accumulate a greater relative share of assets.

de Broglie January 17, 2013 at 6:23 pm

Exactly what I was thinking. There will be a longterm dysgenic trend if genetic engineering or at least embryo selection technologies do not improve. It was interesting to read the paper as a sort of “speculative-fiction what-if” scenario.

Floccina January 18, 2013 at 11:09 am

No the Anabaptists and Hasidic Jews will win the population race.

Noah Smith January 17, 2013 at 9:26 am

I guess I will inherit the Earth, since I save 66% of my disposable income…

anon January 17, 2013 at 10:58 am

Will you adopt me?

Ted Craig January 17, 2013 at 9:27 am

It’s because take-home pay has been declining for the past five years.

JWatts January 17, 2013 at 11:20 am

+1, this seems the simplest and most likely reason.

Claudia January 17, 2013 at 9:30 am

If you are interested in why households borrow from their 401(k)s I would recommend the following empirical paper: http://www.federalreserve.gov/pubs/feds/2009/200919/200919pap.pdf It does not cover the recession/recovery period, but it gives you a sense of what factors might be driving trends. This paper, unlike the links and post itself, make it clear that it may be advantageous for households to borrow from these accounts. I thought the point of Eldar’s work is that scarcity leads to poor decision making, not just borrowing. Borrowing is not, in the abstract, a poor decision…it is simply shifting consumption around over time. Of course, shocks hit households (job loss, medical conditions, etc.) and they need to re-optimize those earlier choices. And yes, re-optimization is hard cognitively, emotionally, and logistically. Consumption smoothing is not tyrannical, its human nature…we are not all pull-the-band-aid-off types. Also, and maybe it’s just me, but I detect a whiff of mood affiliation bias in this post.

Mark January 17, 2013 at 2:00 pm

Best post in here. Particularly the mood affiliation observation. I got the sense TC got up on the wrong side of the best.

Bill January 17, 2013 at 5:23 pm

Claudia,

What are you doing citing to an empirical paper?

This interferes with our mood affiliation–whatever that is.

Andrew' January 18, 2013 at 5:05 am

Not much in the abstract that is counter-intuitive.

Bottom line is that people should borrow from their 401(k) to pay off their dumber borrowings. I’m not sure this contradicts TC’s instincts. When I discuss such an idea with my wife (or taking out a mortgage on our free-and-clear house) I EXPERIENCE risk aversion first hand.

Andrew' January 18, 2013 at 5:09 am

However, one might wonder why one must pay back their 401(k) loan immediately (60 days) upon separation. Seems kind of a stupid policy for recessions.

ad nauseum January 17, 2013 at 9:33 am

Borrowing from one’s 401k has been used as a strategy to buy a house. The rational being that you put a larger down payment on the house, and then pay yourself back, rather than pay the bank more. So, could some of it be from temporary borrowing schemes where they plan to pay it back later?

Orange14 January 17, 2013 at 10:46 am

It’s pretty much of a necessity for a lot of folks since banks are taking a much harder line on credit these days (and well they should). In most areas of the country 20% down is quite a hefty some of money compared to the pre-recession crazy period of no money down.

ad nauseum January 17, 2013 at 10:56 am

That’s why I asked. I may have no data to refer to, but the goal is to put the down payment on the house and then replenish the 401k. Therefore not effecting retirement security in the long term.

john personna January 17, 2013 at 10:49 am

That might be part of a prudent plan, but with mental accounting, the borrower might think the 401K was there all along. Thinking that “since it will be paid back, it is fully funded.” I’d imagine that buying a house, and repaying a retirement fund, would make it very hard to have an authentic, funded, retirement plan.

Ricardo January 17, 2013 at 12:55 pm

The federal government’s TSP also allows this, with a 15 year payback period.

I am under the impression that if you pledge your 401(k) as loan collateral, it becomes a “distribution” and you must pay the penalty. But just borrowing the money directly (for approved purposes) is not penalized.

David Jinkins January 17, 2013 at 10:18 am

Is the article in The Commercial Appeal plagiarized? I see that the byline says “From Our Press Services”. The original article by Michael Fletcher was published in the Washington Post three days ago. I don’t know how citation works in journalism, but if Fletcher is in the byline of the original article shouldn’t he also be credited in reprints?

Turkey Vulture January 17, 2013 at 10:32 am

I’ll admit not learning much about the law in my taxation class, but it seems like a 401k can be used to reduce taxes paid even if you specifically plan to take a non-qualified early withdrawal.

For instance, I live in Massachusetts, and my marginal Federal tax rate will be either 28 or 33% in 2013. However, I do not expect to make as high a salary as I do now for my entire working life. Say that five years from now I want to stop working for a few years and stay home with the yet-to-be-born kids. Say my wife stays home too, and that for simplicity we have no earnings.

If we move to a relatively lower COL area that also has no state income taxes, my understanding is that if I withdraw, say, $30k a year from my 401k, then I would owe normal taxes on that $30k plus a 10% penalty. If that’s our only taxable income, the standard deduction and personal exemptions should cover most of that, so at most we’d be paying a 10% marginal rate on maybe $10k of that. Plus, no State income tax. So we pay the 10% penalty ($3k) and maybe the 10% marginal rate on $10k (so $1k), for a total of $4k in taxes.

That same $30k would have been taxed at a 28% or 33% marginal rate, plus MA state income taxes, for a total of probably $10k in taxes if it had not gone into the 401k. So I avoid $6k in taxes even if I plan to invest in my 401k when I’m 28 and withdraw from it when I’m 35, and pay the 10% penalty.

At least I hope this is right, because that’s kind of my plan right now. It seems like a good way to smooth out uneven expected incomes so as to avoid higher marginal rates.

Also, this same reasoning would seem to apply to using the 401k as an emergency (i.e., medium to long-term joblessness) fund.

Brian Donohue January 17, 2013 at 1:31 pm

Dude,

You can avoid the 10% penalty at any age by making a withdrawal not in excess of the value of a life annuity based on IRS rules.

So, if you’re, say, 50, and have $500K, you can withdraw mebbe $25K a year. If you establish a pattern of a few years of this, you may be able to later suspend these payments on accounta changed circumstances or somesuch, but I think a ‘one-off’ withdrawal under this provision would be…risky.

IVV January 17, 2013 at 10:47 am

Also, how are returns to 401(k) accounts these days? Isn’t really the company match the greatest source of growth in most 401(k) accounts these days?

Chris January 17, 2013 at 12:42 pm

The company match is a big boost to the 401(k)s value. The 401(k) returns this year have generally been very good. But if you look at it since 2008, it’s just made up the losses from previous years and hasn’t grown.

I suspect for people looking to retire in the next 10 years that there’s not much growth to be had. If you are young and still looking at 30 or 40 more years until retirement, a 401(k) is still a very good deal.

Brian Donohue January 17, 2013 at 1:34 pm

True fact: the S&P 500 has increased in value in 9 of the past 10 years, and has earned an annual compound return of 7% during that period.

Rich Berger January 17, 2013 at 4:23 pm

Yes, 7% over the last 10 years is correct; people look at the index number and forget about reinvested dividends.

Rich Berger January 17, 2013 at 10:51 am

I am heartened to hear support from an economist for the lessons taught in the fable of The Ant and the Grasshopper. What’s next – college students have higher GPA’s when they have to pay part of the cost?

Mauricio January 17, 2013 at 10:52 am

Can you expand on “the tyranny of consumption smoothing in welfare economies” a bit?

Andrew' January 17, 2013 at 11:08 am

“t h e t y r a n n y o f c o n s u m p t i o n s m o o t h i n g i n w e l f a r e e c o n o m i e s”

mw January 17, 2013 at 11:21 am

What does this consumption smoothing look like in the majority of countries, that have government funded universal healthcare, dirt cheap universities, government funded child-care, long guaranteed parental leave, etc? What fraction of American borrowing goes to “consume” these things?

Vadim January 17, 2013 at 12:51 pm

Taking out a 401(k) loan is not a taxable event. Only in the event of a default does it become taxable and subject to penalties – basically the unpaid loan balance is reclassified as a distribution.

The bigger tax issue is that the loan repayments are made with after tax dollars. They will be taxed again when distributed in retirement.

dirk January 17, 2013 at 1:50 pm

It’s due to the rise of the Single American. Having no family and living for the moment raises your discount rate.

ihatetrees January 17, 2013 at 3:33 pm

If you’re confident you have ‘enough’ for retirement AND your company matchs ~100% AND you’re in a mid range income bracket, could a disbursement (even with tax ~35%) be thought of a an excellent return on savings? I know, there is a cost: diminished retirement. But that trade off may be worth it.
Or am I missing something?

Millian January 17, 2013 at 3:48 pm

Your colleague has found many excellent correlations. However, do high IQ scores cause rising prosperity, or does rising prosperity drive the pursuit of high IQ?

That’s not to mention the political bias involved in using “Economic Freedom” (i.e. right-wing economics) indices (and I say that as a sympathiser with right-wing economics), not to mention the low-quality Lynn IQ figures.

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