Top 3 reasons to discourage 401(k) loans
July 28, 2009 by Bill MeltzerPosted in: Latest News & Views, Pay and benefits
A recent study found that 401(k) loans are at all-time high. Unfortunately, employees don’t recognize the many ways they’re hurting their own future.
Here are three reasons why employees should only dip into their retirement savings as a last resort.
1. It’s very hard to make up the lost savings
Many people are able to repay their 401(k) loans without incurring penalties. Even so, the lost opportunity for account growth is very tough to make up in other ways. An employee who earns $40,000 a year and takes just a modest $2,500 loan will cost himself nearly $15,000 – even if the loan is repaid in full without penalties.
Another problem: Employees who take out 401(k) loans get taxed twice. Tthe loan itself isn’t taxed, but the repayments come from regular taxed payroll dollars. And unless the employee has a Roth 401(k), the account will be taxed when it’s cashed out upon retirement. But either way, employees end up paying Uncle Sam twice for the same money.
2. Built-in disincentives
While the interest rate on a 401(k) loan may be reasonable, there are often other sorts of fees that jack up the cost of borrowing against the account. Some plans charge fees for processing the loan.
In addition, some employers’ plans disqualify the employee from further 401(k) participation until the loan is paid off in full. This further depletes the employee’s final account balance — often by huge sums of money.
Alternatively, some employees reduce their contributions in order to afford to repay the loan. While this works in the short-term, over the long haul it depletes the value of the 401(k) account.
3. Repayment schedule can change
The repayment schedule on a 401(k) is set as long as the employee remains at the company and eligible to participate in the plan. But if employee loses his or her eligibility to participate in the plan (e.g., a permanent switch from full-time to part-time status, voluntary or involuntary termination), the repayment schedule is out the window. Typically the full repayment is due within 60 days.
What happens if the employee can’t repay? The IRS treats the remaining balance like a cash-out. Now the employee gets clobbered with a 10% penalty and owes income tax on the money.
Education is crucial
While you can’t stop employees from taking 401(k) loans, you can make a priority of drumming home the message that just because 401(k) loans are available doesn’t make it a good option. As a matter of fact, only in case of severe hardship should a plan participant even entertain the thought of a loan. It’s simply not worth all the potential risk and damage to long-term savings.
Tags: 401(k), employee education
July 30th, 2009 at 8:17 am
I partially disagree with this article. Yes you are taking funds that potentially can earn value via interest, dividends and capital gains for the next 5 years (maximum length of loan life barring mortgage related loans), but if you are going to borrow the money, the interest you would normally pay a financial institution (which could really add up) you will be paying back into your own account. The maximum size of such loan is $50,000 (or 50% of account value). I feel retirement plan loans should not be considered as the only option, but it is not as all bad as what this article makes it out to be. The biggest whiners in 401k loans are the brokers/banks losing out on potential income for themselves.
July 30th, 2009 at 10:04 am
In agreement HR in IL. The whole notion of losing earnings while borrowing is faulty because at this time most funds are not generating that much revenue. And, if I have to choose where to pay interest into, I rather pay it into my own retirement account than to a bank…
This is the best time to borrow because your money is not doing a whole lot anyway…
July 30th, 2009 at 11:32 am
I agree with both Gene McIntyre and HR in IL have said. Presuming that the person is borrowing because they actually really need the money [I need to pay for a wedding in six months!], the employee is going to seek out the same amount of funds from another source, usually either credit cards or a home equity loan — both way riskier options in today’s economy (if you can even find a lending institution to agree to the loan). Paying your own retirement account back when the retirement account is not performing at a high level anyway, is the better option for most people.
August 3rd, 2009 at 1:08 pm
I wholeheartedly agree with the content of the article. All of these points have been known to be true and well known for years. The negative responses above just show the desperation that many have gotten themselves into. If it’s not play money- don’t play with it.
August 3rd, 2009 at 4:02 pm
Of course it’s not play money, but the statement that “all of these points have been known to be true and well known for years” is merely a way to validate some opinion by repeating it over & over again. These “points” are certainly not truisms, but sound more like Suze Orman propaganda. Really, the concept that the money is taxed twice is laughable & its presence in the article is no more than a ridiculous follow up to the first paragraph that contains no factual explanation of the $15,000 cost for a $2,500 loan. As to the built-in disincentives, most plans charge from zero to a modest $50 to $75 processing fee for a plan loan. The next point regarding disqualification from deferrals until the loan is re-paid, is an old-fashioned & little used clause in plan documents. Probably the only valid point in this piece is the due in full upon termination of employment issue. This is surely the 800 pound gorilla in the room.
August 3rd, 2009 at 5:23 pm
I generally find the information in the articles quite good–but this one is off target. I have never encountered anyone who thought their 401(k) was play money and I have been in HR for 20+ years. What this article does not address is what would be the cost if an employees takes a personal loan–or worse case scenario a credit card loan/advance (talk about lost savings!!!) I agree with Mike H’s comments that the points stated are definitely not “truisms” and definitely an exaggeration, especially regarding the statement about disincentives. Lastly, I have not seen a “disqualification” due to a loan in years.
August 4th, 2009 at 4:14 pm
There are pros and cons to most all situations. Our plan rep recently spoke with our employees about the state of the market and about taking loans. He explained that while the market is down our funds have more buying power. Therefore, when the market recovers we will earn more. If we remove funds from our accounts for loans, we lose that buying power. That is a basic explanation. However, a 401(k) loan is very convenient. Our plan charges a $75 loan set up fee and has a maximum pay-back period of 5 years.
August 6th, 2009 at 11:08 am
I agree that the article tends to spin the negative side of these loans. The costs of these loans can be more than loans from other sources, but if you are crunched for funds and are not eligible for those other sources, then it is an option. Any employee who gets into such a predicament should seek out some financial counseling before making that commitment, otherwise they could dig a hole like those who used credit cards to pay bills and now can’t pay the credit cards.
August 6th, 2009 at 12:44 pm
Thank you thank you Mike H. Well said and so true. Suze’s faulty logic is spreading like wildfire I see. Thanks for helping to set the record straight.
August 6th, 2009 at 12:57 pm
How is the taxation issue “laughable”? Clearly if you pay something with post-tax dollars and that money is then taxed upon retirement, it is taxed twice. America is in this current predicament because we must borrow, borrow, borrow, borrow because we “have to pay for wedding in six months.” Really? If you have to borrow money maybe you shouldn’t have a wedding.
August 6th, 2009 at 1:30 pm
Simply, while concerns about loans are valid, your recommendation remind me of “Just Say No”.
I am more concerned about some of the recent discussions and suggestions to:
(1) Curtail access to monies using 401k loans, while
(2) Encouraging withdrawals by waiving the 10% early distribution tax penalty.
Modest access and careful, deliberate use of loans can help people save for retirement. Research from the Boston College Center for Retirement Research, Watson Wyatt and others shows that participation declines where access to funds is limited.
As I currently live in Central Ohio, your column also reminded me of what Woody Hays might say if he compared loans to the forward pass – three things can happen when you take a loan, and two of them are bad:
(1) Good – Borrow money, continue regular contributions, pay the loan back,
(2) Bad – Take a loan, suspend contributions (and forego any company match) while repaying the loan, and
(3) Really Bad – Same as #2, but fail to pay the loan back, recharacterize as a distribution, pay taxes and early withdrawal penalty (probably have to borrow more money to pay actual tax bill).
Not sure why you believe:
(1) Individuals who were responsible enough to save in the first place have now lost sight of their sacrifice,
(2) Savers are ill-equipped or irresponsible borrowers,
(3) Savers would suspend contributions & forego company match,
(4) Savers who need money and access a 401(k) loan can easily obtain a similarly secured loan at the same interest rate,
(5) The market rate of interest paid on a loan is less than a market rate on other fixed income investments in the plan.
You state without qualification that “… But if employee loses his or her eligibility to participate in the plan (e.g., a permanent switch from full-time to part-time status, voluntary or involuntary termination), the repayment schedule is out the window. Typically the full repayment is due within 60 days. …” It just isn’t so.
What you should recommend is that plan sponsors and recordkeepers update loan processing to 21st Century standards – to help ensure loans will be repaid:
(1) That contributions continue while a loan is being repaid,
(2) That processing change to electronic methods so:
(a) Repayments can continue after termination, and
(b) New loans can be initiated after termination.
(3) Recordkeepers adopt rollover provisions that facilitate moving outstanding loans to the new employer’s 401(k) plan.
My 401(k) plan has had this 21st Century loan processing capability for over five years.
And, again, you are wrong about loans. Recent trends confirm most participants don’t borrow from a 401k.
However, modest access and careful, deliberate use of loans can actually help people save for retirement. Research from the Boston College Center for Retirement Research shows savings often decline if access to money is limited. And, retirement preparation would be significantly enhanced if people saved more than they “earmark” for retirement – that is, access allows people to save more than what they would save solely for retirement. Then, when you borrow the money to meet a non-retirement need, and repay the loan, you rebuild the account for future use – ultimately retirement.
The priority here should be to ensure loans are considerably more attractive than withdrawals and to update loan repayment processes to 21st Century standards.
Finally, associates at my company who have loans not only tend to repay those loans, but their 2007 average contribution percentage is less than 1/2 of 1 percent lower than those who used 401k loans.
August 6th, 2009 at 1:36 pm
Jo, the argument neglects to include the part where the participant gets to withdraw the money without paying tax on it. There are 4 transactions, not 3 as Suze’s argument proposes.
(1) The money is put in to the account pre-tax. (2) It is withdrawn (borrowed) without paying tax on it. (3) It is then repaid with after tax dollars. (4) Then the money is taxed at retirement when withdrawn.
To be allowed to repay the loan with pre-tax dollars would result in the participant reaping the pre-tax benefit twice.
August 6th, 2009 at 1:42 pm
For a better explanation see the link below:
http://thefinancebuff.com/2008/07/401k-loan-double-taxation-myth.html
January 11th, 2010 at 9:14 am
I have administered 401(k) plans for almost 30 years as a TPA (third party administrator). I always encourage my clients to put in a loan provision in their plans for several reasons: (1) participants are more inclined to contribute if they can have access in an emergency (2) they’re paying themselves the interest (3) they can typically get a better rate than a commercial loan (4) plan sponsor flexibility on how tight or loose they make the loan reason restrictions (any reason versus IRS hardships only) and (5) if the need was satisfied by a hardship withdrawal (no payback) the money is gone from the plan — forever. Loans substantiate that this is a retirement plan, but you can dip in if you really neet it.