Unexpected expenses can come up at any time and present a need for a family to take out a loan. For those who have put money into a defined contribution plan, such as a 401(k) account, a 401(k) loan can be an easily accessible way for a family to help smooth over a rough patch in their financial situation. Because it is your money, there is no approval to worry about, there’s a competitive interest rate on the borrowed funds, and you can borrow up to half of your account balance with no penalty as long as you repay it within five years.
Taking out a 401(k) loan, however, does not come without consequences. While the money is covering your pressing expenses it is not sitting in your retirement account and thus not receiving an investment return. And while that competitive interest rate is attractive when you are thinking of yourself as a borrower, it isn’t as attractive when you have to think about yourself as the lender. Although interest payments that you must pay yourself will help to grow your account, you will pay them in after-tax dollars, and you will have to pay taxes on that again when you receive money from the account after you retire. Also, if you fail to repay your loan, you will then have to pay taxes on the amount in addition to a 10 percent penalty fee.
People borrow from their 401(k) accounts because they have to. They may, for example, use the loans as supplemental unemployment insurance and health insurance, or to make ends meet when they are financially tapped out. Importantly, research has shown that there is no indication that 401(k) loans have been primarily driven by a desire for more conspicuous consumption—spending to “keep up with the Joneses”—but rather seem to reflect economic necessities. As our recent report shows, 401(k) loans are taken out in addition to other forms of debt and not used as a substitute for higher priced debt.
Given the current economic downturn, policymakers should carefully consider the future implications for today’s 401(k) loans as Congress looks into the 401(k) loan trend. Over the past few years families have tried to bridge the widening gap between income growth and the cost of necessities—especially food, housing, energy, and healthcare—by amassing growing amounts of household debt, sometimes seeking out additional financial resources, including their retirement plans. More and more families are leveraging their future retirement security to cover their current financial insecurity. Given that 401(k) loans can reduce retirement income security by potentially more than 20 percent—depending on how many loans are taken, when they are taken out, and how quickly they are repaid—today’s 401(k) borrowers could be tomorrow’s financially insecure retirees.
The solution is not to eliminate 401(k) loans, but rather to eliminate the reasons that people are finding themselves in situations where they need to borrow from their accounts in the first place. That’s why Congress needs to reform our health insurance system and increase families’ savings outside of retirement accounts to help to reduce the likelihood that a family would be confronted with the need to borrow from their 401(k). Additionally, harmful loan options, such as 401(k) debit cards, should not be supported.
Christian E. Weller is a Senior Fellow at the Center for American Progress and Associate Professor of Public Policy, University of Massachusetts Boston.