Have you suffered a loss of income because of the pandemic? If so, you’re not alone. Millions of workers have been laid off or had their hours or pay reduced – in many cases permanently. Meanwhile, you must continue to pay for life’s necessities – housing, utilities, groceries, medical expenses and more, while still trying to build up your retirement savings. What can you do?
You might be tempted to tap into your workplace retirement plan to cover these needs. That’s exactly what nearly one in three American workers did in 2020 – and 43% did so multiple times, according to the Tapping Retirement Assets Early study Edelman Financial Engines conducted last year.
Some might have been enticed because the CARES Act made borrowing from retirement plans easier; maximum loan sizes were also increased to $100,000. Yet more than half of the borrowers (55%) in our survey told us they’ve regretted their decisions. Indeed, 85% admitted they made their decision without understanding the consequences. More than 4 in 5 (81%) said a financial advisor could have helped them make a better decision.
Simply put, taking a 401k withdrawal is a life-changing decision because it can seriously harm your ability to achieve financial security in retirement. You could lose as much as half of your potential retirement savings from a single loan event! Here’s how.
Let’s say Mary at age 45 has $100,000 in her 401k. She takes out a $50,000 loan and never repays it. By age 70, if she hadn’t borrowed any money from her plan, 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, or to buy a car or pay for car repairs so you can keep getting to work. But, sad to say, employees 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.”
Once their “lifeline” is gone – because retirement funds are depleted or borrowing limits are reached – many employees’ financial stress only worsens. Employers suffer, too, because workers who are under financial stress are less productive at work. Too often, employees who take a 401k withdrawal don’t understand these critical points: They incur fees to obtain a loan and pay interest when repaying it. They also incur a penalty if they don’t repay the loan on time.
The term “borrow” is really a misnomer. In reality, the “loan” is a withdrawal of funds from a 401k plan; mutual fund shares in the account are sold to provide the “loan.” Those shares therefore no longer exist, causing the employee to miss out on any subsequent return in those shares’ values. Some employees are not allowed to continue contributing to their accounts until the loan is fully repaid, and employer matching is discontinued. These add to the missed gains during the repayment period.
Meanwhile, being unable to contribute to the plan increases the worker’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.
As you can see, taking withdrawals from your retirement account is fraught with many problems. It’s partly why we always recommend that you maintain sufficient cash reserves – so you have the financial flexibility you need to cover unforeseen expenses. If your financial situation has changed during the pandemic, you should carefully consider all your options–before you withdraw funds from your retirement account.
This is a hypothetical illustration meant to demonstrate the principle of compound interest and is not representative of past or future returns of any specific investment vehicle. They do not include consideration of the investment fees or expenses, time value of money, inflation, fluctuations in principal or taxes.