Investors Regret Paying Off Debt with a 401(k) Loan

Ever wish your Future Self could go back in time and tell the Past You mistakes to avoid? It’s the old “If I only knew then what I know now…” thing. Since we still don’t have flux capacitors and DeLorean time machines, perhaps it’s best to simply learn from the mistakes of others. More than four in ten (44%) investors who have borrowed from their 401(k) retirement plan savings regret the decision.

It’s a big lesson to learn. Nearly one-third (29%) of Americans who participate in a 401(k) have borrowed savings from their plan —  of those, 43% have taken out two or more loans, based on the results of a new study by TIAA-CREF

When thinking about tapping an employer-sponsored retirement plan through a loan, you’ll hear people say things like, “Why not? I’ll be paying interest to myself!” But the TIAA-CREF research says a $10,000 loan paid back over five years could mean missing more than $3,500 in potential earnings. The comparison is based on a 6% interest rate on the loan versus an 8% market return. With dividends reinvested, the S&P 500 has gained an annualized 9% return over the past 20 years.

In addition, more than half (57%) of investors cut their retirement savings contribution rate while paying back the loan.

Another downside: Retirement plan loans can trigger taxes and penalties if not repaid in a timely manner. If you leave your job with a balance remaining on the loan, you may be forced to pay it off within 60 days or claim the amount as a taxable distribution.

The primary reason given by respondents for taking a loan from their retirement plan savings was paying off debt (46%). Other reasons included:

  • Paying for an emergency expenditure (35%)
  • Home purchase or renovation (26%)
  • Paying bills due to a job loss (24%)
  • Education costs for self or children (20%)
  • Special event like a wedding or family vacation (15%)

Plan participants facing an emergency need may have an alternative to a loan: applying for a hardship withdrawal, if permitted by your employer. In certain instances, such as avoiding foreclosure or to cover medical expenses, you can access your savings but not without a cost. You’re likely to owe income taxes – and if you’re under age 59 ½, you may also incur a penalty for a premature distribution.

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