There is deep and growing concern in America that people are going to get to retirement with insufficient funds to live a comfortable or even basic standard of living. Probably not a major concern for the kinds of people who may read this blog. Many of us are striving for an early retirement and squeeze every saving opportunity there is out of our working life to fund it. But we all know it’s a scary situation for our friends, coworkers, and family who may not take saving as seriously as we do.
Professionals in the retirement plan industry talk about something called ‘plan leakage’. This refers to the ‘holes’ by which participants are permitted to take money out of their retirement savings, thereby undermining the long-term success of your personal retirement readiness. It includes all kinds of withdrawals. The ones that people take when they liquidate their 401(k) after leaving their job, hardship withdrawals under limited IRS permitted circumstances, and then lastly 401(k) loans.
Some sponsors don’t want the hassle of loans or they fundamentally think that allowing them is not in the best interest of employees so they don’t permit them. Granting plan loans is not required, but about 80-90% of plans do allow them.
According to Vanguard, an average of 16% of 401(k) participants had an outstanding loan in 2015. The average balance was just under $10,000.
The downside to taking a 401(K) Loan:
It’s easy to see that having payroll deductions to repay your loan is super convenient. And taking 5 years to repay it sounds like a good deal too. If you default on the loan, it isn’t reported to the credit bureaus (but it is taxable, plus a 10% penalty depending on your age).
There are 3 main drawbacks to consider:
- Just like with a personal loan you may take from a bank or your credit cards, you are getting no favorable tax treatment on your loan repayments. You are repaying the loan with after-tax dollars. From this regard, they are no better or worse than other options (interest rates being equal) however if you are opting for a 401(k) loan instead of a tax-favored student loan, then that may not be a good idea.
- While your money is outside of your account, it’s not earning interest, it’s not increasing in value, and it depresses your overall return and ability to reach your retirement saving goals.
- Lastly, you could lose your job for a number of reasons which may not be apparent to you at the time you take the loan out. If you lose your job, you will have a limited time to repay the outstanding balance in full to avoid taxation plus penalties. Most plans require loan repayment within 60 days or at the end of the quarter to avoid reporting it to the IRS as a taxable withdrawal. If this happens to you, you’ll get a 1099 at tax time. Some plans are slowly allowing loan repayments after termination through ACH/Direct Deposits but this has been slow to catch on with most employers.
If 401(k) Loans Were Not Permitted, Would People Invest Less?
One of the concerns is that if your retirement money is not available to you under extreme financial duress, then people may not contribute to them at all or may contribute significantly less.
In contrast, contributions to a Roth IRA (outside the workplace) are far more flexible and you can take out your contributions for just about anything (but not the earnings if you don’t want to pay taxes early). This sounds like a good reason to fund those Roth accounts when you are eligible to do so in case you need to tap into some of the money (but try not to do that!)
What about IRAs?
If you aren’t in a workplace 401(k) and have a Traditional IRA instead, you are not permitted to borrow from this account. Some people tout that you could technically take a short-term 60-day loan from your IRA without penalty, but this rule is intended to give people sufficient time to move money between providers in a rollover situation. You can take up to 60 days to put your money back into the same account or another Traditional IRA. I don’t think this really qualifies as a ‘loan’ in the traditional sense and I think it’s misleading to talk about it as a loan.
As stated above, Roth IRAs have some additional and attractive flexibility to withdraw (not borrow) your contributions at any time.
I can certainly see advantages and disadvantages to allowing 401(k) loans. If we want to encourage folks to actively save, there has to be a way for them to access the funds if they really, really need it to avoid incurring unfavorable debt or even avoid bankruptcy.
What concerns me though is the loose attitude that many people take towards these loans. I often see employees take out a new loan the minute their existing loan is paid off. It’s a vicious cycle they get into. Maybe it’s too easy and there isn’t enough thought put into the downsides?
What do you think? If you were prevented from borrowing against your 401(k), would it affect your decision to contribute and save? Have you ever taken out a 401(k) loan and if so, what did you use it for?