What Makes 401(k) Loans Risky?

The new tax law eases the timeline for repayment following a job loss — but borrowers should still be wary.
What Makes 401(k) Loans Risky?

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Congress has decreed that people should have more time to pay back their 401(k) loans if they lose or leave their jobs. That extension isn’t enough to make 401(k) loans safe, though. You’re still risking your retirement security every time you take money out of your plan.

Loans from 401(k)s are certainly popular. People can borrow up to half their balances, up to a maximum of $50,000, at favorable interest rates and pay the money back through payroll deductions, typically over five years. About 40% of 401(k) savers borrow from their plans in a given five-year period, and 90% of the loans are paid back, according to Olivia S. Mitchell, executive director of the Pension Research Council at the Wharton School of the University of Pennsylvania and co-author of a 2017 study called “Borrowing from the Future? 401(k) Plan Loans and Loan Defaults.”

Risk #1: If you lose your job, the loan may become a withdrawal

When people get fired or quit, though, they typically must repay the balance of the original loan as a lump sum, and that’s when the odds turn against them. The researchers found 86% of those who change jobs with outstanding 401(k) loans fail to pay the money back as fast as the law requires, which is typically 60 days after their departure.

That default turns the loan balance into an inadvertent withdrawal, which triggers taxes and penalties. The researchers estimate the IRS collects $1 billion in taxes and penalties each year on $5 billion in defaulted 401(k) loans. Those withdrawals also represent tens of billions of dollars in lost future retirement income, since the money that’s withdrawn is no longer earning tax-deferred returns for the future.

Risk #2: The grace period to repay has been extended

The longer grace period, part of the recently enacted tax cut law, extends the deadline to pay back loans from 60 days to mid-October of the year following the year in which taxpayers lose or leave their job. (The deadline is the due date of a federal tax return extension, which is typically Oct. 15 of the following year.)

As before, people have several ways to avoid taxation and penalties, says Stephanie Napier, senior counsel for the investment company Vanguard. They can pay back the loan to their old employer or deposit an amount equal to the loan balance into an individual retirement account or a new employer’s plan, if the employer allows that option.

The new law doesn’t require the former employer to let borrowers continue making loan payments on the original schedule, although some large employers currently allow terminated employees to do that, says Amy Reynolds, a partner at Mercer, a health and benefits company.

Risk #3: The lump-sum repayment still looms

The fact that people still have to make lump-sum payments is a problem. The reason most people don’t pay back their loans now is because they don’t have the cash, particularly after a job loss, says study co-author Steve Utkus, a principal at the Center for Investor Research at Vanguard. Even if they’re given more time, many still may not be able to come up with a lump sum — particularly if they’ve been unemployed for a while.

Retirement plan loans have other problems. Many borrowers reduce or eliminate their contributions while repaying a loan, stunting the amount they can accumulate. Borrowed money is taken out of investments that could be earning substantial returns — often higher returns than the interest borrowers pay out of their own pockets.

Then there’s the concern that the longer grace period itself could lure more people into a false sense of security, leading to more loans — and more defaults. Making loans more attractive “is not the approach you want if your primary goal is retirement security,” Mitchell says.

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