The temptation to take loans from a company 401(k) retirement savings plan is apparently too hard to resist for some people even after they’ve been warned of how dipping into that account can knock their retirement plans off track.
“In addition to the loss of compounding interest, there are other potential downsides or perils of utilizing a loan provision from a 401(k),” said Curt Knotick, owner of Accurate Solutions Group in Butler. “One would be taxes — more importantly, paying double taxation on the interest you pay for the loan itself.”
While research by the Federal Reserve Bank shows a small percentage of workers use their 401(k)s as a honey pot to fund vacations and live beyond their means, the majority of such loans are used to make downpayments on homes, consolidate high interest credit card debt, buy cars and pay for educational and medical expenses.
And in recent years, it seems a growing number are a last resort to handle emergencies when the account owners are out of cash and out of options for getting what they need.
A recent report by the Investment Company Institute in Washington, D.C., showed loan activity from company 401(k) plans is higher today than it was seven years ago. As of the end of September 2015, 17.6 percent of 401(k) plan participants had loans outstanding, compared to 15.3 percent with outstanding loans at the end of 2008.
The increasing number of workers taking loans from their retirement accounts could be a sign of financial stress, said Sarah Holden, senior director of retirement investor research at ICI.
“For some individuals, it may make more sense to take advantage of the 401(k) loan and pay yourself back rather than pay some other lender,” she said.
Not all 401(k) participants have access to a loan feature. The Center for Retirement Research at Boston College estimates about 90 percent of employers offer loans.
The Internal Revenue Code limits the borrowing to 50 percent of the account balance up to $50,000. Loans do not require approval, but generally must be paid back within one to five years.
But such loans do come with risks. If a 401(k) loan is not repaid due to default or job loss, the remaining balance is treated as a lump-sum distribution and is subject to income taxes and a 10 percent penalty for borrowers who have not reached age 591/2.
Knotick said there is another tax issue that many people don’t take into consideration.
“You will be paying back the loan with interest and using after-tax dollars to pay that interest,” he said. “Then once back in the 401(k) account, when you withdraw those funds for retirement in the future, you will be paying taxes again — since with a traditional 401(k) account, withdrawals are taxed at the time of distribution.”
The 401(k), which came onto the scene in 1978, has primarily replaced company pensions as the dominant workplace retirement plan. Pensions provided a monthly fixed income for retirees. The idea behind a 401(k) also is to create income for workers in retirement, which is why financial advisers typically consider such funds off limits until retirement.
“When we exercise a loan from our 401(k) which is to be utilized for retirement, we lose the compounding of those dollars, since they are no longer in the plan,” Knotick said.
“That can have a dramatic impact over the course of 10, 15 or even 20 years. Don’t underestimate that impact ...
“Remember, the 401(k) was created to plan for retirement, and not for use prior to then.”