Are thousands of 404s a problem?
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An ecommerce site I work on has around 16,000 URLs that are 404s in Webmaster Tools. The vast majority are for products that are no longer stocked by the site, which is a natural occurrence in ecommerce.
But my question is, could these possibly be harming rankings?
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It's not necessarily an SEO problem (as long as you don't redirect all 404s to your homepage at least. I've seen that be an issue in the past.)
However, use it as an opportunity. Make the 404 a sales page if you have that many. It's a lander now for "the product you were searching for is out of stock - here are the search results on our site for similar products" etc. You can turn it into something productive to have that many 404s.
From WMT, mark them as fixed and then anytime one pops up, find out what is linking to the product and try to remove that link. You don't want to be linking to 404s internally if you can help it (bad user experience = Google's nightmare) so having 1000s of 404s isn't bad but try to break any internal links to them. (Xenu can help as well if you don't feel like waiting for WMT.)
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As Kevin stated they do not directly impact your ranking.
The user experience might be harmed if the 404 page is not optimized for the user.Using a custom 404 page you can assist the user to further explore the website on which they have arrived. If this is not done they might immediately leave the website and visit another one.
Google uses usage metrics in it's rankings now and therefor a lot of 404 pages might indirectly impact rankings.
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