For many employees, autumn is benefits season. It’s the time of year when employees review their health insurance, disability insurance, retirement savings plan and other employer-sponsored benefits and make any needed adjustments. The benefit enrollment period is also a good time to see if you have taken out a loan off your 401(k). If you have, get rid of it fast.
A majority of 401(k) plans offer participants the option of taking out a loan on their retirement savings while working. A recent scholarly paper suggests too many workers are taking advantage of the option. In “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” researchers found that over a five-year period nearly 40 percent of 401(k) participants took out a 401(k) loan. It’s hard enough to save for retirement without borrowing from the plan.
To be sure, these loans aren’t the typical loan-disaster story. About 90 percent of the 401(k) loans in their study were repaid. Defaults among the remaining loans are mostly associated with leaving an employer, voluntarily or involuntarily.
The word “default” is misleading, however. When you leave your employer for whatever reason the 401(k) loan comes due within a relatively short period of time. The outstanding balance must be paid back or the withdrawn money is considered an early distribution from your retirement plan. The 401(k) borrower is hit with a 10 percent penalty on the amount still outstanding, plus the borrower owes income taxes on the money that hasn’t been paid back. In other words, your credit rating doesn’t take a hit. The price is you have less in retirement savings.
A 401(k) loan is expensive. Yes, I have heard many times the observation that a 401(k) loan is cheap money because you are paying yourself back rather than the bank. While true, the aggregate price of the loan is high. For one thing, employers often won’t allow borrowers to contribute to their 401(k) account until the loan is paid off. In that case, you are missing out on the employer’s match. You can’t take advantage of the tax break for putting pretax dollars into the account. You can’t enjoy the compounding effect of investment gains that might have come your way if you were contributing into the plan with every paycheck.
Retirement savings plans are designed to shore up financial security in the elder years. We all know from experience that setting aside money for the elder years isn’t easy. You want to add to retirement savings, not subtract. The 401(k) loan isn’t a good way to borrow.
Chris Farrell is senior economics contributor, “Marketplace,” commentator, Minnesota Public Radio.