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.
