Why You Should Think Twice About 401(k) Loans

Source: Thinkstock

Source: Thinkstock

It may not feel like it now, but every dollar you spend or save today affects your future retirement income. While numerous factors impact compounded returns over one’s lifetime, nothing may be more damaging than improper use of 401(k) loans.

You should think twice before borrowing from your future. According to a new analysis from Fidelity, nearly one million clients initiated a loan from their 401(k) over the past year. In order to help pay back these loans, clients often reduce contributions or completely stop saving. This could easily lead to hundreds of dollars in monthly retirement income being lost due to the earning potential of dollars invested over time.

“The number of investors borrowing from their 401(k) has trended upwards in recent years, with more than two million investors now having an outstanding loan,” said Doug Fisher, senior vice president, of Thought Leadership and Policy Development, Fidelity Investments. “Fidelity’s top concern is that within five years of taking a loan, 40 percent 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.”

What are the long-term costs with decreasing your 401(k) contributions? Fidelity conducted a hypothetical analysis of three 401(k) investors who started saving at age 25 — six percent employee contribution and a four percent employer contribution for a 10 percent total savings rate — with an annual salary of $50,000. The analysis looked at three separate savings scenarios.

A person maintaining the previously stated savings rates are estimated to receive monthly 401(k) payments of $2,650 in retirement. However, someone reducing their savings rate to 5 percent for 5 years receives an estimated $2,470, while a person who reduces their savings to zero percent for 10 years only receives $1,960 per month. As a result of reducing contributions for long periods of time, a retiree may unintentionally reduce monthly 401(k) payments by $180 to $690.

Borrowing from your 401(k) plan can be one of the best options if you truly have a short-term liquidity crunch with no other solution. A 401(k) loan is typically quick, straightforward, and probably offers an interest rate more attractive than traditional consumer loans or credit cards. You also don’t have to rely on a bank lender or pass a credit check. However, in addition to lost retirement income, the typical 401(k) loan is due in full within two or three months if you part ways from your employer for any reason. If you are unable to pay back the loan during this time period, your loan enters default and you are subject to taxes and possibly a 10 percent penalty if you are under retirement age.

Follow Eric on Twitter @Mr_Eric_WSCS

More from Personal Finance Cheat Sheet:

Want more great content like this? Sign up here to receive the best of Cheat Sheet delivered daily. No spam; just tailored content straight to your inbox.