Think twice before taking a 401 (k) loan

For those strapped for cash, borrowing on a 401 (k) plan seems like an easy way to deal with a short-term budget crunch. However, experts such as Catherine Collinson of the Transamerica Center for Retirement Studies argue that the risks of pursuing such a strategy outweigh the benefits.

Most plans allow investors to borrow money as long as they repay themselves with interest or make a withdrawal that meets the plan’s definition of financial hardship, which can mean anything from medical bills to higher education expenses.

Plan operators have encouraged users to take out these loans in recent years, which Collinson described as a “wolf in sheep’s clothing”. Nonetheless, they are popular and have become the preferred source of quick cash since declining real estate markets made it more difficult to obtain home equity loans. Indeed, early withdrawals and loans gained popularity in 2010, at the height of the economic downturn.

According to a recent Transamerica poll, 27% of Gen X investors either took out a loan against their 401 (k) or an early withdrawal. Similar results have been found among baby boomers. In this group, 23% of those surveyed used their 401 (k) plans. The trend among Gen Xers is particularly noticeable as they were the first generation to start their careers in the 401 (k) era, according to Transamerica.

“Gen Xers estimate their retirement savings to be $ 1 million (median),” the organization noted. “This generation entered the workforce in the late 1980s when 401 (k) were making their first appearance and defined benefit plans were starting to disappear. … They greatly appreciate them as a significant benefit, have high plan participation rates and, for better or worse, some have taken out loans and withdrawals early. ”

This trend worries Collinson for several reasons. First, people who do not repay themselves in five years and are under 59 1/2 are subject to penalties of 10% for early withdrawals. It can be expensive for investors. IRS data cited by Bloomberg News indicate that Americans withdrew $ 57 billion from their retirement accounts before reaching the minimum age to do so. Investors who take out loans also fall behind in their retirement savings, as 401 (k) contributions are often suspended until the loan is paid off.

“It’s a double whammy in that regard,” she said, adding that lending had been encouraged in previous years because “it was believed to help boost savings and participation rates. ‘is that it has been about five to seven years since the real drawbacks or dangers appeared. “

Investors should only consider a 401 (k) loan if they have exhausted all other sources of money. Even then, they should borrow as little as possible and should start contributing to their plans again as soon as possible.

The question of 401 (k) loans highlights the poor retirement savings for many Americans. The Transamerica Center estimates that 34% of Gen Xers and 41% of Baby Boomers expect a “significant” drop in their standard of living after retirement.

“In 2010, 40 percent of families in their peak savings years (55-64) had nothing saved in retirement accounts and 10 percent had $ 12,000 or less, according to survey data of the Federal Reserve on consumer finances “, Institute for Economic Policy noted in a recent report.

Many workers plan to work even after they retire part-time because they cannot afford to enter their golden years. If they find themselves in bankruptcy, they can take comfort in knowing that their 401 (k) plans are protected from creditors. But it’s also important to make sure your retirement savings are protected against unnecessary borrowing.

Updates are released to correct the incorrect investigation number and clarify issues with 401 (k) loans.

Sara R. Cicero