That’s not my metaphor which is why it’s in quotes. It belongs to Eve Tahmincioglu, the Career Diva, about whom I wrote in 2008. Eve wrote a blog post about the increasing number of 401(k) loans, It’s for retirement stupid…, which very directly expressed her sentiments. Just to reinforce it, her parting words were
People, this is a temporary Band-aid, and it’s going to hurt when you have to rip it off.
That’s pretty much been the opinion since then until recently. J.R. Robinson, writing in the Christian Science Monitor yesterday says Now could be a great time to borrow from your 401(k). He provides a number of advantages why this could be an appropriate personal financial strategy.
Mr. Robinson also cites a November, 2014 article in the Journal of Financial Planning to support his premise. That article, Benefits and Drawbacks of 401(k) Loans in a Low Interest Rate Environment, written by Jarrod Johnston, Ph.D., CFP®; and Ivan Roten Ph.D., CFP® provides a number of scenarios in which 401(k) loans are advisable.
The authors do point out that a major disadvantage is a deemed distribution if the loan is not paid back. The defaulted loan is taxable at ordinary income tax rates. In addition, a 10% early withdrawal penalty applies f the borrower is younger than age 59½.
But just how prevalent is this major disadvantage of loan default, and what is it’s impact on retirement savings? A February, 2014 Pension Research Council Working Paper written by Timothy (Jun) Lu, Olivia S. Mitchell, Stephen P. Utkus, and Jean A. Young provides us the answers. Their study, Borrowing from the Future: 401(k) Plan Loans and Loan Defaults (registration required to download), focused on answering the questions:
- Who borrows from their 401(k) plans?
- Who defaults on an outstanding loan?
- What are the implications of 401(k) borrowing for retirement security?
Here is what their research shows:
- At any one time, 20% of defined contribution participants have an outstanding loan.
- Approximately 40% of all participants borrow against their 401(k) accounts over a 5-year period.
- While 90% of all loans are repaid, 86% of employees who terminate with loans default.
The authors estimate that loan defaults are approximately $6 billion per year which is larger than previous estimates. The data implies, the authors say, that this high rate of defaults could be for reasons of low financial literacy, impatience, or inattention. Many employees, they found, were surprised by an unanticipated job change or its effect on an outstanding loan.
Public policy and plan design considerations aside, the takeaway for me is more immediate: more and better financial education in the workplace.