Requests for 401(k) loans jump about 16% from June to August, Charles Schwab found. To add to the problem, many borrowers are unable to repay the loans.
Catherine Golladay, Schwab vice president of Participant Services, told PLANADVISER this increase in 401(k) loans in the summer seems unrelated to economic downturn. Charles Schwab has been tracking this loan data since 2005, and Golladay said the 16% rate has remained the same on average—but why?
College funding is one main reason participants take 401(k) loans in the summer, Golladay explained. Another reason is cash flow, as participants may have used their income tax refunds to bridge a gap earlier in the year and need additional funds in summer.
While taking out a 401(k) loan may seems like a quick an effective fix, Golladay cautioned that doing so can cause many long-term financial consequences:
While people repay their loans, they usually stop contributing to their 401(k) plans. “When you’re taking a loan from your 401(k) plan, many times it’s because you’ve got challenges with cash flow,” Golladay said.
Loans are paid back into a 401(k) with after-tax money, which ends up getting taxed again when it is withdrawn at retirement. Essentially, Golladay explained, participants will be double taxed. “It really does have what could be a devastating effect on your account,” she added.
Little Time to Repay Loan
A loan borrower who leaves his job—whether voluntarily or by termination—will likely be required to repay the 401(k) loan in one lump sum to the previous employer. “Very few employers allow you to pay it back in payments,” Golladay cautioned. The full loan amount is sometimes due as soon as 30 days after a borrower leaves the company.
Risk of Bigger Financial Problems
Golladay said she has spoken with many people who took a loan from their 401(k) to pay one or two mortgage payments and avoid foreclosure. Unfortunately, taking this loan is not part of a long-term financial plan and only provides a short-term solution. In the end, many end up losing their houses anyway. “They’re really just kicking the can down the road for a month or two,” Golladay said.
How Plan Sponsors and Advisers Can Help
Individuals tapping their 401(k) accounts likely are experiencing a larger financial issue, she said, which is where plan sponsors and advisers can help.
Advisers and sponsors can teach employees a broader sense of how to manage money to avoid taking a 401(k) loan, Golladay said. This can include encouraging employees to budget, have an emergency fund and pay off credit card debt.
Plan sponsors should also be aware of what is happening within their companies. Are 401(k) loan rates within the company similar to the broad trend? Golladay said this information can help sponsors and advisers design the best education strategy.
Before the summer begins, sponsors should schedule a meeting to illustrate the pitfalls of taking 401(k) loans, she added.
In addition, sponsors should reconsider the loan provisions in their plans; advisers can provide them with benchmarking data to help determine the best plan design around this, Golladay said.
“I think from a plan sponsor perspective, certainly we would encourage employers to help think of a plan design that would help incent the behaviors that you want,” she added.
In the past, employers offered loan provisions to incent employees to participate, but Golladay said automatic features may be incentive enough. “I’m not so sure that [kind of] thinking is as important as it was years ago,” she added.