401(k) Loans – The Real Cost. Participants who opt to take a loan from their 401(k) might not understand the risks involved. As a plan sponsor, you can help educate them on why borrowing from their retirement savings isn’t generally the best idea.
A recent article penned by personal finance writer Liz Weston for NerdWallet details the risks of 401(k) loans. It’s great information you can use to help your participants understand why tapping their retirement plan account for an immediate financial need can have serious consequences down the line. Here are some of the highlights.
First, retirement plan loans can cost your participants dearly. Sure, the interest rates are low — usually the prime rate (4.75% as of this writing) or prime rate plus one percentage point — but many participants reduce or stop their retirement plan contributions when repaying a 401(k) loan, which can drastically reduce their retirement income.
Weston gives this example: If a participant in their 30s borrows $10,000 today, it could cost them $190,000, or $1,000 a month in lost income in retirement. Someone in their 20s could be looking at a potential loss of $380,000, or $2,000 a month in lost retirement income.
Real-life examples like this could make a dramatic impact on participants and help them see, in real numbers, how taking a loan today could put a crimp in their ability to live well in retirement.
Additionally, these examples assume repayment of the loans. But what about workers who quit or lose their jobs? One study found that 86% of those who left their jobs defaulted because they didn’t repay their loans within the required 60 to 90 days. A default can result in taxes and early withdrawal penalties equivalent to 25% or more of the loan balance. That’s not pocket change.
When put to them that way, participants may actually think twice about digging in to their 401(k) savings to meet today’s financial obligations. It’s another way you can communicate the realities and risks participants face when they choose to take a 401(k) loan.
What’s more, by borrowing against their savings instead of remaining invested, participants miss out on the benefits of compounding over time, which eats away at their potential returns. Again, it’s important to educate participants on the perks of keeping their money in their 401(k) account — including compounding — and encourage them to find other ways to meet more near-term financial needs.
Many participants continue to contribute to their 401(k) while repaying their loans, although generally at a lower rate. Moreover, most borrowers tend to be older — loan activity peaks for participants in their 40s. As such, the impact of cutting back or stopping contributions is even more significant because they have less time to save until they retire.
Before borrowing from their 401(k), your participants should ask these questions:
- Do I need this loan because I’m living beyond my means? If the answer is yes, they need to reign in their spending first. Otherwise, their current financial problems will stick with them in retirement.
- Do I have a plan to avoid default? Can I use savings or other resources to pay off the loan quickly if I leave my job? Can I tap those instead of borrowing from my 401(k)? Again, encourage participants to look for other outlets to cure a financial pinch besides their retirement savings.
- Can I continue contributing to my retirement account while repaying my loan? It’s important to convey to participants that they should be consistent with their 401(k) contributions, and/or step up their deferrals once the loan is repaid.
For some participants, borrowing from their 401(k) may be their only option, and many will still make that choice, even if they “get” that it isn’t a great idea. But an effective communication program that educates them on the potential pitfalls and drawbacks of taking a 401(k) loan can help participants make better-informed, and hopefully, smarter decisions.
There are additional insights on how to design loan programs from the International Foundation for Employee Benefit Plans.
