401 (k)’s are primarily a retirement savings vehicle, however, in recent years the amount of 401 (k) loans has increased. Employees that are borrowing from their retirement funds are hurting their financial futures. Here’s why.
401 (k) loans explained
Employees may borrow against their 401 (k)’s when they’re in a financial bind. They likely see their 401 (k) as a kind of savings account or emergency fund. However, experts agree that withdrawing money early or taking out a loan from your 401 (k) is simply not a good idea.
Unfortunately, many employees turn to 401 (k) loans because they don’t understand the implications and it will likely be too late before they realize what they’ve done. In other words, the negative effects of 401 (k) loans won’t be felt until retirement rolls around.
The cause of 401 (k) borrowing
401 (k)’s are likely the largest accumulation of money for your employees
Employees without sufficient savings, or an emergency fund, may have no other options when they’re in a financial bind. Although a 401 (k)’s primary role is as a retirement savings vehicle, employees still view them as a source of cash when they need it.
It’s usually easy and convenient to take out a 401 (k) loan
There are serious disadvantages to taking out a 401 (k) loan, however, employees may not understand just how serious the disadvantages are because of how easy and convenient it is to take one out.
401 (k) loans are enticing to employees because:
- There’s no loan application
- No minimum credit score is required to take out a loan
- Employees can generally choose to borrow up to half of their 401(k) balance or $50,000, whichever is less
- They repay the loan with automatic paycheck deductions over a maximum term of five years (so it seems simple enough)
The negative effects of 401 (k) loans are usually delayed
Unfortunately, the consequences of borrowing from your retirement account aren’t felt in the present. This makes it harder for your employees to understand how borrowing today will affect their future.
401 (k) loans negatively affect employees’ futures because:
- There’s less money in their account at retirement than they would have had
- Taking out a loan and then defaulting can cause even greater loss
- Bad money habits aren’t altered
Less money for retirement
Even if your employees successfully repay their 401 (k) loans, they can end up with less money for retirement than they would have had if they’d never taken out a loan. One reason is they’re losing out on the power of compounding interest while the borrowed money is out of their retirement accounts.
In addition, many employees decrease or stop contributing to their 401 (k)’s while they’re repaying the loan, sometimes for as long as five years. This further reduces the base available to compound for their future retirement.
Defaulting can cause even greater loss
If employees default on their loans, this can trigger even more borrowing. Many borrowers in default withdraw additional funds from their retirement accounts in order to cover the taxes and early-withdrawal penalties that they owe on their existing loans. According to Gursharan Jhuty, senior manager at Deloitte Consulting, about two-thirds of participants who default liquidate their accounts. When employees liquidate their accounts they’re then worse off for the future and often have no additional retirement savings.
Bad money habits aren’t altered
Employees who take money out of their retirement accounts are likely in bad financial shape. They may need the help of a professional financial counselor to help them make changes to their lifestyle and spending habits. In addition, talking with a professional financial counselor could provide them with alternatives to a 401 (k) loan or at the very least, make sure they fully understand the implications of borrowing from their future.
Financial wellness programs can help stop the cycle
The bottom line is, 401 (k) loans should be a last resort for your employees. However, many employees won’t know where else to turn if they need money. Financial wellness programs including financial counseling and access to emergency funds can help get your employees back on track.