The 401(k) plan has become the foundation of retirement security for most Americans. Sadly, it's a flimsy foundation, with the average American across all age groups having account balances far below what experts consider enough to support a comfortable retirement.
One feature of this type of tax-advantaged retirement account that some financial advisors think should be scrapped is the ability to borrow from it under certain circumstances. Roughly 90 percent of 401(k) plan participants have the right to borrow as much as 50 percent of their account balance, up to a maximum of $50,000, without paying taxes on the sum or the 10 percent penalty for early — meaning, before age 59½ — withdrawals from the account. Borrowers can take up to five years to pay the loans back.
According to the Center for Retirement Research at Boston College, 11 percent of plan participants borrow from their 401(k) plan each year and about 20 percent currently have a loan outstanding to their account, based on data from Vanguard Group, which administers plans for more than 24 million Americans.
Ric Edelman, founder and executive chairman of Edelman Financial Services, thinks individuals should never borrow from their 401(k) plan.
"It's not a loan; it's a withdrawal, and it's a really bad idea," said Edelman, who advises more than 30,000 clients. He believes people should exhaust every other option available to them before touching the money they are saving for retirement.
"Using the money should be your very last resort," he said. "If you still have a television set or jewelry, you haven't exhausted all your options."
Others see the loan provision in 401(k) plans as more benign and even desirable because it increases participation rates in the plans and possibly increases the amounts people are willing to contribute to them.
The Boston College research center sees outright withdrawals and cash-outs on job transitions as much bigger sources of "leakage" from 401(k) accounts. It estimates that 2 percent of assets in 401(k) plans are withdrawn annually, resulting in an average reduction in eventual retirement wealth of about 25 percent.
"The loans are typically not for large amounts, and the majority are paid off," said Geoff Sanzenbacher, an economist at the center who used a 401(k) loan to purchase his first home out of graduate school. "My other credit options were very expensive.
"I think having a loan provision in plans is a good thing."
There is no question that the average American should be contributing as much as he or she can to a 401(k) plan — and then leaving those savings as untouched as possible to appreciate for the future. The quality of their lives in retirement will depend on it. Here are the cases for and against borrowing from your future.
- There is strong evidence that participation rates in 401(k) plans increases if people have the right to borrow from them without paying taxes or the 10 percent withdrawal penalty.
- Hardship loans from 401(k) plans are allowed for a variety of reasons, including medical expenses, funeral costs, home repairs, certain tuition expenses, down-payments on primary residences and rent to avoid eviction. While arguably none of these situations are worth the hit to your future retirement wealth, a loan from your 401(k) plan may be the only option available for people to deal with circumstances.
- The loan doesn't impact your credit rating even if you default on it. If you fail to repay it within the term of the loan, you will be liable for taxes and potential penalties on the amount.
- A 401(k) loan does carry an interest rate but this is typically much lower than are available from third-party lenders. The interest also flows back into your retirement account. A low-cost loan from your 401(k) plan may be far more manageable than racking up debt on a high-interest credit card. "It comes down to comparisons with other funding options — particularly for lower and middle-income participants," said Sanzenbacher. "If you have no access to credit or only at very high rates, the 401(k) loan may not be such a bad idea."
- The money you borrow from your 401(k) plan won't earn you any return. A loan will force you to sell investments in the account and forego any appreciation in the assets. "Not only will you miss the upside until the loan is repaid, but when you do put the money back, you'll have to invest at new [and potentially higher] prices," said Edelman of Edelman Financial Services.
- If you lose your job or quit the 401(k) plan, the loan must be repaid within 60 days or you're liable for taxes and a 10 percent penalty on the amount.
- Borrowing from your retirement account can have adverse tax consequences. For one thing, the interest payments on the loan are not tax-deductible and will face double taxation. For example, a $50,000 loan carrying a 5 percent interest rate will generate $2,500 annually in interest that will be taxed at your marginal income tax rate. It will be taxed again when withdrawn in retirement. Many plans also don't allow you to make other pre-tax contributions until the loan is fully repaid, meaning your income and taxes could be higher during the repayment period. Lastly, if you default on the loan, the full amount is taxed as regular income and you're also liable for a 10 percent penalty on the balance. "Add all the factors up and every $10,000 you borrow from your 401(k) plan will reduce your future wealth in retirement by $100,000," said Edelman.
- Americans, on average, already have woefully inadequate savings in their retirement accounts. Borrowing from those accounts will only compound the problems they may face down the road.
"I don't care what kind of crisis people feel they're facing today," Edelman said. "It's nothing compared to the crisis of reaching retirement with no money."
— By Andrew Osterland, special to CNBC.com