The Pitfalls of Taking a 401(k) Loan

By Jessica Kmetty

Does retirement sound like a stress-free period of life where you aren’t exhausting yourself for a paycheck and can make your own schedule? For the 80 percent of Americans who believe they won’t have enough saved for retirement, “stress-free” may be the last term they would use to describe it. If many of us are already concerned about having enough money saved to retire, why would we hinder our savings ability by taking a loan from the very account where our nest egg should be growing? One answer: because we can.

A loan provision on an employee-sponsored retirement plan allows participants to take out a loan from their account for any reason they deem necessary. We’re not talking about a “hardship provision” which lets employees distribute money for a specific hardship; rather, a loan provision is an unregulated way for an employee to borrow whenever, for whatever they want. Christmas gifts? A vacation? Are these really reasons to put your financial future in jeopardy? Consider these pitfall examples:

Example #1 – By not offering a loan provision on their company’s retirement plan, one business owner may have saved his employees countless headaches. A natural resources firm was doing well – they had a 401(k) plan with high employee participation and routine contributions, positive cash flow and an effective management team. Because of the attractiveness of their company, they were sought out by another reputable entity for a merger. However, the merger was a bad move for the company that forced them into bankruptcy. All employees were terminated and the 401(k) plan was terminated as well.

Imagine if there had been a loan provision on the plan – employees who thought everything was going great at their company and who felt they had job security could have taken out a loan against their retirement plan. Any active loans at the time of termination would have either had to have been paid back immediately, or the distributed amount would have been counted as an in-service distribution which can include penalties, fees and interest for non-eligible plan participants.

Example #2 – An HR mistake lands an executive in trouble. A business executive who needed a loan started the paperwork to borrow from her 401(k) plan. She flawlessly filled out the paperwork, understood the amortization schedule and submitted it to human resources to schedule the repayments from her paycheck. It wasn’t until a year later that she discovered the HR team member hadn’t setup the payroll correctly meaning the executive hadn’t been making payments on the loan for an entire year. Not only did the executive have to pay penalties and interest, but her company took a hit as well for failing to execute the loan properly.

Example #3 – They should have stayed invested in their retirement plans. A husband and wife both took the maximum loan from their 401(k)s to invest in a business venture. They had no trouble making the payments until the business venture folded and they lost their entire initial investment. But, that wasn’t the end of their hardship. Not only did they lose the business, they still had to repay the loan on time with no alternative for refinancing.

Remember, the purpose of a retirement plan is to save for your future retirement. It is the pile of money that you will use to pay yourself a paycheck in retirement (it is your future income stream.) If employers make it easy for employees to get to that money early, behavioral science proves that many will want to take that money. If we really are going to have an opportunity to retire with dignity someday, we all need to invest regularly, leaving the money to grow, so that our retirements can be funded and build value over time. Keep your endgame in mind and don’t compromise your future financial security.

Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this content, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for you or your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Searcy Financial Services, Inc.

The content of this letter does not constitute a tax or legal opinion. Always consult with a competent professional service provider for advice on tax or legal matters specific to your situation. To the extent that a reader has any questions regarding the applicability of any specific issue discussed in this content, he/she is encouraged to consult with the professional advisor of his/her choosing.  

Published for the blog on May 16, 2017 by Searcy Financial Services, your Overland Park, Kansas Fee-Only Financial Planner and Investment Manager.