Let’s say that Mary, age 45, has $100,000 in her 401k and takes out a $50,000 loan, but never repays it. If she hadn’t borrowed that money from her plan, by age 70, her assets would have grown to $1.2 million (assuming a 6% annual contribution rate and 3% employer match). But if Mary defaulted on the loan, at age 70, she would have only $590,247. That’s 50% less.
Borrowing from your retirement account is never ideal, but life sometimes makes it unavoidable. For example, you might need money for medical care, to avoid eviction, to buy a car or pay for car repairs so you can drive to work.
Those are legitimate and necessary expenses, but unfortunately, people often have frivolous or at least questionable reasons for accessing their retirement savings early.
Among those we surveyed, the top reason for taking out such loans was to pay down credit card debt. Other nonessential reasons included vacations, weddings and simply “fun spending.”
And once their “lifeline” is gone – because retirement funds are depleted or borrowing limits are reached – many people find that their financial stress only worsens.
To make matters worse, all too often, those who take a 401k withdrawal don’t understand these critical points:
- The term “borrow” is really a misnomer. In reality, the “loan” is a withdrawal of funds from a 401k plan.
- They will pay fees to obtain the loan.
- They will pay interest while repaying it.
- And they can also incur a penalty if they don’t repay the loan on time.
In order to “fund” this load, mutual fund shares in the account are sold. Which means those shares no longer exist, causing the borrower to miss out on any subsequent return if those shares rise in value. Some plans don’t allow individuals to continue contributing to their accounts until the loan is fully repaid. So not only are they prevented from saving for retirement, but they’ll also miss out on employer matching contributions. This just adds to the missed gains opportunities during the repayment period.
Meanwhile, being unable to contribute to an employer-sponsored plan increases one’s take-home pay, raising tax liabilities. Money in a 401k plan is also protected from creditors. But once you remove it through a loan or withdrawal, that protection is lost and creditors can sue, forcing you to repay, negotiate a settlement or seek bankruptcy protection.