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The overall state of retirement readiness in the United States is poor, according to many recent studies and reports. In this light, you have to wonder about the wisdom of taking a loan from a 401 (k) plan. The Employee Benefit Research Institute stated that 21% of participants whose plans allowed them were able to borrow in 2012 and currently have an average unpaid balance of more than $7000.
Not all plans include credits. There are usually rules regarding why a loan can be taken out, the percentage of your account that can be forgiven, the number of outstanding loans, and the repayment period. The flexibility afforded participants by 401 (k) loans may make it easier for some to contribute, although they should be used carefully and generally only after all other sources of funding have been tapped. There are some exceptions, so let's look at the pros and cons of 401 (k) loans. (For more information, see: The 401 (k) and Qualified Plans Tutorial .)
Cons
There are so many cons to talking about a 401 (k) loan that this could get tedious, but here are a few:
Leave your job. This can make the loan balance due immediately and has many implications. If you are let go of your position, your loan could be due and payable immediately if you are in a vulnerable financial situation at the same time. If you don't have the money to pay off the loan, the balance could become a distribution, subject not only to income tax but also a 10% penalty if you're under 59 ½. An outstanding 401 (k) loan could keep you trapped in a job for the same reason, as leaving for a better position could trigger the same results. (For more information, see: 8 reasons to never get out of your 401 (k).)
Loan fees and expenses. Most 401 (k) plan providers and platforms charge fees for processing and servicing a loan. This increases the cost of borrowing and repayment.
Opportunity cost. While you pay interest when you repay the loan through payroll deductions, the interest rate pales in comparison to what you could earn if you were fully invested in your 401 (k) account. Standard & Poor's 500 index up more than 200% from 2009 market lows to end of 2014. Investors with a large portion of their 401 (k) tied up in loans lapsed. (For more information, see: Bonds from your retirement plan .)
Retire to finance a depreciating asset. This is generally a bad bet. Raiding your retirement to buy a new refrigerator or a big-screen TV is just a bad move. Long after these purchases have been repaid and replaced, you will still be in your retirement account balance.
Pros
The main reason is that loans are available in many plans. While 401 (k) loans are best avoided, the reality is that they are sometimes needed.Life events don't always go our way. Such things as medical expenses, the threat of losing your home, and other bad events occur and it's nice to know that this funding source is available. (For more information, see: Sometimes it pays to take advantage of your 401 (k).)
When to avoid
In general, there are several specific situations in which loans should be avoided whenever possible ..
- You're approaching retirement.
- You're back at retirement age.
- Your job security may be at risk.
- You plan to quit your job in the near future.
- You can tap other sources for the money you need.
- You believe repaying the loan will cause financial hardship.
A 401 (k) loan in either of these situations can lead to a financial train wreck. Whether it's retirement, a diminished quality of life, or a burden of taxes and penalties you're not prepared for, it's especially important to avoid a 401 (k) loan in the above circumstances. For more information, please visit: Should you take advantage of your retirement plan? )
How advisors and plan sponsors can help
Investors working with financial advisors should already be getting advice to help them plan for big purchases, except in college and generally for financial emergencies. While even the best laid plans can be derailed, financial planning can help avoid the need to tap expensive capital via a 401(k) loan. Planning includes not only saving for emergencies and high out-of-pocket expenses, but also insurance for things like health and disability.
Sponsors of 401 (k) plans also get the message that they need to help their employees make good financial decisions. Financial stress means huge loss of productivity at work. Inadequate retirement savings also have consequences for organizations such as workers who don't retire on time, which can cause a logjam in the careers of younger workers the organization wants to retain. Some of this is certainly related to the reasons employees take 401 (k) loans, and leads participants to put pressure on their retirement savings efforts. (For more information, see: When a 401 (k) Hardship Withdrawal Makes Sense .)
The bottom line
The ability to get a 401 (k) loan is considered a good feature. That employees have the flexibility to borrow if they find themselves in financial difficulty. A loan should not be made lightly and should be the last source of funds. It's hard enough for many to save for retirement without using their main retirement savings vehicle as a piggy bank.