A loan from your 401(k) plan has well-known drawbacks, among them the taxes and penalties that may be due if you lose your job and can’t pay off the loan in a timely way. But there is a subtler issue too: millions of borrowers cut their contribution rate during the loan repayment period and end up losing hundreds of dollars each month in retirement income, new research shows.
Academics and policymakers have long fixated on the costs of money leaking out of tax-deferred accounts through hardship withdrawals, cash-outs when workers switch jobs, and loans that do not get repaid. The problem is big. Some want more curbs on early distributions and believe that funds borrowed from a 401(k) should be insured and that the payback period after a job loss should be much longer.
Yet most people who borrow from their 401(k) plan manage to pay back the loan in full, says Jeanne Thompson, vice president of thought leadership at Fidelity Investments. A more widespread problem is the lost savings—and decades of lost growth on those savings—that result when plan borrowers cut their contribution rate. About 40% of those with a 401(k) loan reduce contributions, and of those a third quit contributing altogether, Fidelity found.
To gauge the impact, Fidelity looked at two 401(k) investors making $50,000 a year and starting at age 25 to save 6% of pay with a 4% company match. Fidelity assumed that at age 35 one investor stopped saving and resumed 10 years later. At the same age, the other investor cut saving in half and resumed five years later. Both employees earned inflation-like raises and the same rate of return (3.2 percentage points above inflation). At age 67 they began drawing down the balance to zero by age 93.
The investor who stopped saving for 10 years wound up with $1,960 of monthly income; the investor who cut saving in half for five years wound up with $2,470 of monthly income. Had they maintained their savings uninterrupted each would have wound up with $2,650 of monthly income. So the annual toll on retirement income came to $2,160 to $8,280.
Nearly one million workers in a Fidelity administered 401(k) plan initiated a loan in the year ending June 30, the company said. That’s about 11% of all its participants and part of rising trend, the company says. The typical loan amount is $9,100 unless the loan is to help with the purchase of home—in that case the typical amount borrowed is $23,500.
These figures are generally in line with data from the Employee Benefit Research Institute, which found that the typical unpaid loan balance in 2012 was $7,153 and that 21% of participants eligible for a loan had one outstanding. The loans were relatively modest, representing just 13% of the remaining 401(k) balance.
Workers change their contribution rate for many reasons, including financial setbacks and a big new commitment like payments on a car or mortgage. But cutting contributions to make loan payback easier may be the most common reason—and the least understood cost of a 401(k) loan.