Adding further pressure: Our research shows four in ten participants already carries revolving debt.1 Loans from 401(k)s, along with early withdrawals, tend to have a toxic effect on retirement portfolios.
Here’s what you need to know.
Consistent saving and investing is critical
Consistently saving and investing over time is the key to retirement funding success. As an example, let’s take someone with a starting salary at age 25 of $30,000 and a 2.4% increase in wages each year. If they contribute to their 401(k) plan consistently, they can end up with nearly $1.4M in retirement at age 65.
Loans and withdrawals can undermine retirement portfolios
Now, what if that same person took loans and withdrawals during this time period? In slide 26 from the Guide to Retirement, we show someone borrowing $10,000 loan at age 32 and again at 50. At age 62, they take a $10,000 withdrawal. While the earlier loans were each paid back within five years, during the repayment period, this individual was unable to make additional retirement contributions. This, in turn, forced them to miss out on receiving their company match. Moreover, with less in the account, opportunities for compound interest growth were also reduced.
What does this mean for the portfolio balance at retirement? Even though both loans were paid back, and only $10,000 was withdrawn, the ending balance was $400,000 less than it might have been without these funding disruptions—or 28% less in retirement savings.
Consider other ways to manage unexpected expenses
Building up a healthy emergency savings fund can help avoid borrowing from a retirement account. For current workers, we recommend setting aside the equivalent of two to three months of net income to cover unexpected expenses. However, if taking a loan seems unavoidable, consider the following:
1. Explore alternative payment options
- Is it possible to save/pay for an expense over time rather than taking a loan?
- Are there other accounts to draw on, such as a brokerage account or, if the expense is a large one, a home equity line of credit?
- Can the individual negotiate the expense to a lesser payment or extended payment schedule? In particular, this may be an option for large medical bills.
2. Mitigate the loan's impact
- If borrowing from a retirement account is inevitable, mitigate the impact by continuing contributions while repaying the loan. It is especially important to ensure they continue to receive an employer match, if available.
- Understand the plan’s loan repayment policy, especially if they expect to leave their job. Loan payment is often accelerated or due immediately if an individual leaves their company. Further, a loan that’s not paid back on time could be counted as a taxable distribution. Borrowers who have not yet reached age 59 ½ may also incur an early withdrawal penalty.
Prepare for the unexpected
Credit card debt, healthcare and housing-related expenses are significant drivers of loans and withdrawals from 401(k) plans.
Being prepared for unexpected spending challenges in these two categories can help increase overall financial wellness, reduce the risk of accumulating credit card debt and, ultimately, enable reaching long-term retirement funding goals.