And 5 Reasons to Steer Clear
A recent study shows more retirement plan participants are taking loans from their retirement accounts, and they’re borrowing larger sums of money than in the past. According to data provided by Empower, a retirement plan administrator to 5.3 million accounts, 2.6% of plan participants (approximately 138,000 people) took a loan from their employer-sponsored plan during the third quarter of 2023. This is up from 2.3% in the third quarter of 2022 and 1.7% in 2020.1
Fidelity, which is the nation’s largest retirement plan administrator, saw a similar increase, with 2.8% (or 641,000 people) requesting loans in the third quarter of 2023, up from 2.4% in the third quarter of 2022.2
The average loan amount has also increased in recent years. In a recent survey conducted by Plan Sponsor Council of America, the average 401k loan in 2022 was $15,000, up from $10,000 to $11,000 between 2018 and 2021.3 As of June 2023, the average outstanding loan balance is $8,550.4
The popularity of 401k loans may be partly due to the fact that 70% of retirement plan participants report they don’t have enough in emergency savings to cover six months of expenses.5 So, it may be that participants are using these loans to pay for unexpected costs.
In the event of a financial crunch, many consider borrowing from their 401k because the loan could be faster and cheaper than other types of credit. However, despite their popularity, 401k loans can be highly detrimental to your long-term financial security. Following are five reasons to avoid borrowing from your employer-sponsored retirement account.
#1 – Long-term savings impact
Perhaps the biggest downside to taking a loan from your 401k is that you’ll have less saved for retirement. Taking money from your retirement savings can significantly impact your savings potential over time.
#2 – Opportunity cost
Keep in mind that one of the most significant advantages of contributing to a retirement account is the opportunity for tax-deferred growth and compounding interest. You miss out on this growth opportunity when you remove assets from the account. Even a small loan can significantly impact your long-term savings when accounting for this missed growth opportunity.
Consider the following chart, which illustrates how missing out on just a few days in the market can significantly impact a portfolio’s performance over time.
#3 – Double taxation
Contributions to employer-sponsored retirement plans are typically made with pre-tax dollars. You’re then taxed on your assets when you withdraw them in retirement. However, 401k loan repayments are made with after-tax money, meaning you need to earn more than you borrowed to repay your loan. In addition, your repayment amount will still be treated as a pre-tax source of income when you withdraw funds in retirement. That means you are paying taxes twice on any loan amount you repay to the plan.
For example, suppose you fall into the 24% tax bracket and take a loan from your pre-tax retirement plan. Every dollar you earn to repay your loan is taxed at 24%, meaning each dollar is worth only $0.76 after taxes. In order to make your retirement account whole again, you’ll end up paying 24% more than what you borrowed (not including interest).
In addition, you don’t get credit for having paid taxes on the loan repayment amount. That means when you withdraw the funds in retirement, they’re taxed again as ordinary income. If you remain in the 24% tax bracket, each dollar you withdraw from the loan repayment is again worth only $0.76. That’s a hefty tax consequence!
#4 – Missed contributions
Some retirement plans prohibit participants from making regular deferrals while they have an outstanding loan balance. Not only does this prohibition restrict the amount you can set aside in retirement savings but it may also make you ineligible for employer matching contributions. That’s a double hit to your long-term savings.
#5 – Repayment requirements
If you leave your job for any reason, you’ll have 60 days or until the date you file your next tax return to pay off your outstanding loan balance. If you fail to do so, your outstanding loan balance becomes a taxable distribution subject to ordinary income taxes as well as a potential 10% early withdrawal penalty if you haven’t yet reached age 59 ½.
Could you use some help assessing the pros and cons of taking a loan from your retirement plan? Creative Planning is here for you. Our wealth managers stand ready to help you make intelligent retirement planning decisions aligned with your overall financial goals. To learn more, schedule a call with a member of our team.