What are the Consequences of 401(k) Loans?

In a her paper “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” Olivia Mitchell, Wharton professor of business economics and public policy, analyzes why plan participants take loans from their 401(k) plans and how plan sponsors might better control the employees’ behavior.

Somewhat surprisingly, she finds at any given time, about one fifth of all plan participants have a current 401(k) loan. Over some five-year periods, she found as many as 40% with outstanding loans. The common practice raises the question of why plan participants use their retirement nest eggs as today’s piggy banks.

To encourage workers to leave their accounts untapped until retirement, Mitchell suggests plan sponsors could make some simple changes. For instance because she found that if a plan permits multiple loans, participants are more likely to borrow, she suggests a new one loan at a time rule. Education, too, can change behavior. She says outreach should target the young, low paid and cash strapped, who tend to borrow from their 401(k)s more frequently.

Mitchell notes that she was most surprised to learn that many people default on their loans when they leave their jobs, “It’s expensive to default,” she writes. “You have to pay income tax plus the tax penalty. I think most people don’t realize how big a burden that can be. So we need to get the word out in terms of the cost of defaulting on the loans.”

While Mitchell doesn’t think outlawing loans is the answer to this problem, she believes loans should be structured “judiciously and thoughtfully” in order to change participants’ behavior. In addition to prohibiting multiple loans, plan sponsors could cap the amount that could be borrowed at a time.

Whether you borrow from your 401(k) plan or not, it’s important to understand your plan’s rules — including all the fine print.

 

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