Loans May Have Ripple Effect on Retirement Plan Savings

Taking a retirement plan loan can have a big impact on a participant’s retirement income, especially if the participant does not pay the loan back or stops contributing to the plan at the same time.

“The number of investors borrowing from their 401(k) has trended upwards in recent years, with more than 2 million investors now having an outstanding loan,” says Doug Fisher, senior vice president of thought leadership and policy development for Fidelity Investments. “Fidelity’s top concern is that within five years of taking a loan, 40% of borrowers decrease their savings rate, and more than a third of those stop saving altogether. Reducing your savings rate today could significantly reduce your account balance upon reaching retirement and therefore your monthly income in retirement.”

Fidelity conducted a hypothetical analysis of three 401(k) investors with an annual salary of $50,000 who started saving at age 25 with a 6% employee contribution and a 4% employer contribution for a 10% total savings rate. At age 35, one investor reduced his deferral to 0% for 10 years, one reduced his deferral rate so that his total savings rate was 5% for five years, and one maintained the 10% total savings rate. Based on certain assumptions, Fidelity found the first two experience a decrease in monthly income in retirement of $690 and $180, respectively.

According to Fidelity, over the past year alone, more than 27,000 investors took loans specifically for the purchase of a home. While it’s a small percentage of Fidelity’s overall 401(k) loan-taking population, it is a trend the company has seen increasing over the past five years. Today’s average loan for home-buying is $23,500, far higher than the average general loan value of $9,100. It represents 25% of an average borrower’s 401(k) pre-loan balance, versus 17% for a general loan.

Millennials borrow on average 37%, or $17,100, of their retirement savings balance for a home. According to Fidelity, borrowing so much at this young age could be a stretch for people who are also taking on a mortgage and might be saddled with student debt.

A greater portion of Gen X took loans for home-buying than Millennials or Boomers, averaging $25,600, or 26% of their balance. Borrowing one-quarter of a person’s balance during these crucial income years makes it all the more difficult to stay on track with retirement savings if they reduce or stop saving, according to Fidelity. Fidelity’s savings rule of thumb indicates Gen X should have an amount equal to a full year’s salary saved for retirement at age 35, and an amount equal to three year’s salary at age 45.

Fidelity contends participants considering a loan should be reminded of three implications:

  • If moving to a new job, any outstanding loan balance typically must be repaid within 60 days. Plan rules may vary.
  • Borrowers unable to continue saving at the same pre-loan rate while repaying their loan may adversely impact their monthly retirement income.
  • Loans are paid back with after-tax dollars, which can negatively impact the tax-deferred savings benefits of a 401(k).