Think twice before taking a loan from your 401(k)

Last Updated May 7, 2014 2:15 PM EDT

For people short of cash, borrowing against a 401(k) plan seems like an easy way to address a short-term fiscal 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 pay themselves back with interest or take a withdrawal that meets the plan's definition of a financial hardship, which can mean anything from medical bills to higher education expenses.

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

According to a recent Transamerica survey, 27 percent of Generation X investors have taken either a loan against their 401(k) or an early withdraw. Similar results were found among baby boomers. In that group, 23 percent of respondents have tapped their 401(k) plans. The trend among Gen Xers is especially noteworthy since they were the first generation to start their careers in the 401(k) era, according to Transamerica.

"Generation X estimates their retirement savings needs to be one million dollars (median)," the organization noted. "This generation entered the workforce in the late 1980s just as 401(k)s were making their first appearance and defined benefit plans were beginning to disappear. ... They highly value them as an important benefit, have high plan participation rates, and, for better or worse, some have taken loans and early withdrawals."

This trend worries Collinson for several reasons. First, people who don't pay themselves back in five years and are under the age of 59 1/2 are subject to 10 percent penalties for early withdrawals. This can cost investors dearly. Data from the IRS cited by Bloomberg News indicate that Americans took $57 billion out of their retirement accounts before they reached the minimum age for doing so. Investors who take loans also fall behind in their savings for retirement because contributions to the 401(k) are often suspended until the loan is repaid.

"It's a double whammy in that regard," she said, adding that the loans were encouraged in previous years because "there was a thought that it would help drive savings and participation rates. It wasn't until about five to seven years ago that the real downsides or hazards came to light."

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

The issue of 401(k) loans highlights the poor state of retirement savings for many Americans. The Transamerica Center estimates that 34 percent of Generation Xers and 41 percent of baby boomers expect a "significant" drop in their living standards after retirement.

"In 2010, 40 percent of families in their peak saving years (age 55-64) had nothing saved in retirement accounts and 10 percent had $12,000 or less, according to data from the Federal Reserve Survey of Consumer Finances," the Economic Policy Institute noted in a recent report.

Many workers are planning to work even after they retire on a part-time basis because they can't afford to ease into their golden years. If they wind up 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 post to fix incorrect survey number and clarify issues related to 401 (k) loans.

  • Jonathan Berr

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