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EMPLOYEE BENEFIT VIEWS
An excerpt from our Employee Bene t Views blog, written by Robert C. Lawton, founder and president of Lawton Retirement Plan Consultants.
Why 401(k) loans are the worst possible investment
Taking a 401(k) loan is such a bad investment choice that it should not be allowed in any 401(k) plan other than for hardship reasons. And yes, it is an investment because when plan participants take 401(k) loans, they become one of the investments in their accounts.
Before allowing workers to pull money out of their accounts, employers and employees should consider these importance factors.
Borrowers often lose the company match. Many participants who borrow from their 401(k) accounts end up stopping or lowering their 401(k) contributions while they are paying back their loans. is often results in the loss of 401(k) matching contributions when a participant’s contribution rate falls below the maximum matched percentage.
Job changes can force defaults. Most participants considering a job change don’t realize that their outstanding 401(k) loan balance becomes due when they leave their current employer. In the case of involuntary job loss, an outstanding 401(k) loan can add signi cant pain to an already dif cult situation. Regardless of whether a job change is voluntary or involuntary, most participants don’t have the nancial resources available to pay back their 401(k) loans when they separate from service. As a result, a large percentage of these participants are forced to default. e defaulted balance becomes subject to state and federal taxes and possibly state and federal early withdrawal penalty taxes. Plan balances that leave a 401(k) plan forever before retirement are referred to as leakage. “Leakage” from defaulted 401(k) loans makes it less likely that participants will build adequate retirement savings.
Opportunity costs can be substantial. Assume that a participant takes a $10,000 loan for ve years at 6%. e investment experience on that portion of the participant’s balance will be a 6% return for ve years. Had the loan balance been invested in the investment options in the plan for the same period, the participant may have earned a lot more. For example, the ve-year return on the Vanguard 500 Index Fund through March 31, 2017, was more than 13%.
Interest on a 401(k) loan is not tax-deductible. Anyone needing a loan should investigate the possibility of taking a home equity loan rst, since interest on these loans is tax-deductible.
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