(Bloomberg News) Workers will be limited in tapping their 401(k) retirement plans for loans under legislation two senators plan to introduce today that's designed to counter the erosion of retirement assets.

"During these difficult economic times, we are increasingly seeing 401(k) funds being treated as rainy-day funds," Senator Herb Kohl, a Wisconsin Democrat, said in a statement obtained by Bloomberg News. "A 401(k) savings account should not be used as a piggy bank for revolving loans."

Kohl, 76, who's chairman of the Senate Special Committee on Aging, plans to introduce the "SEAL 401(k) Savings Act" with Senator Mike Enzi, 67, a Wyoming Republican. The bill would reduce the number of loans workers may take from a 401(k) and give participants more time to repay after losing a job. It will allow savers to contribute to their plan after taking a hardship withdrawal and ban debit cards linked to the accounts, according to Joe Bonfiglio, a spokesman for Kohl's aging committee.

The Senate bill would limit the number of outstanding loans for each participant to three, Bonfiglio said. Employers would have the option to reduce the number for their plans.

Almost 28 percent of participants in 401(k)-type accounts had an outstanding loan at the end of 2010, which is a record, according to a study released today by benefits consultant Aon Hewitt, a unit of Chicago-based Aon Corp. The average outstanding loan balance was $7,860, said Aon Hewitt, which used a database of about 2 million employees in 110 plans.

Leaving A Job

"The big risk with loans is that participants leave their job," said Alison Borland, head of retirement strategy for Aon Hewitt. Most 401(k) plans require employees to repay loans in full when leaving a job, usually within 60 days, said Borland, who's based in Nashville, Tennessee. Almost 70 percent default, Borland said, so the unpaid funds get counted as taxable income and may add to the burden of a jobless worker.

Depending on the rules of an employer's 401(k) plan, workers generally may borrow from their retirement account for any reason and pay the loan back with interest. About 89 percent of participants were in plans offering loans in 2009, according to the Washington-based Employee Benefit Research Institute, which has a database of 21 million 401(k) savers.

Workers generally may borrow as much as 50 percent of their vested account balance up to a maximum of $50,000, according to the Internal Revenue Service. The loan must be repaid within five years, unless the money was used to buy a primary home.

Payroll Deductions

Employees can repay the loan through payroll deductions and can continue to make contributions to their retirement accounts, Borland said. More than 80 percent of those with a loan do continue to save, she said.

"For these workers who take a loan, repay it and continue to save, they haven't done significant damage to their retirement prospects," Borland said. "They are at significant risk if they change jobs or lose their job."

The average interest rate on loans from 401(k) plans is the prime rate plus 1 percent, currently 4.25 percent, David Wray, president of the Profit Sharing/401k Council of America, said in an e-mail. The median loan origination fee in 401(k) plans is $75 and the median annual loan maintenance fee is $25, according to the council, a Chicago-based non-profit association of employers that sponsor retirement plans.

For workers who lose their jobs before repaying a loan, the bill would let them pay down their balances into an individual retirement account before filing their taxes for that year. That way the saver doesn't incur a withdrawal tax penalty on those funds, Bonfiglio said. The IRS and Treasury Department would need to issue guidance on how the process will work, he said. About $663 million of 401(k) loans in 2008 were deemed taxable distributions, according to a December report by the Department of Labor.

Hardship Withdrawals

The flexibility to take loans or withdrawals is an attractive feature of the accounts for some participants, said Sarah Holden, senior director of retirement and investor research for the Investment Company Institute, a mutual-fund trade group based in Washington.

"Knowing that you can borrow the money if you need to frees people to participate in the plan and contribute more," she said.

A 401(k) plan's terms also may let individuals take a hardship withdrawal that doesn't have to be repaid if they demonstrate a financial need such as medical or funeral expenses. That money generally is included in an employee's income for tax purposes and may trigger an additional 10 percent tax penalty, according to the IRS. Employees also are generally prohibited from making contributions to their account for at least six months after taking the withdrawal, the IRS said.

The legislation would allow participants to continue to contribute during the six months following a hardship withdrawal because the loss of employee and company matching contributions during that period can further erode retirement savings, according to Kohl's statement. Kohl said on May 13 that he won't seek re-election next year.

Debit Cards

The bill also would ban products that promote so-called leakage of savings including 401(k) debit cards, which may carry high fees, Bonfiglio said. While use of 401(k) debit cards are not widespread, they have been offered by companies in the past, he said. Using the card essentially triggers a loan.