Many 401(k) plans allow participants to take out loans from their individual 401(k) account—While loan options provide flexibility for those tentative to contribute to 401(k) accounts, the option to borrow can also have a negative impact on retirement security.
In my research for an International Foundation member on reasons why individuals borrow from their retirement savings plans, I found there is much debate over whether plan sponsors should permit or restrict loans. The law does not require your 401(k) plan to make loans available to participants. The law doesn’t restrict how loan proceeds are used, although some plans establish acceptable reasons similar to hardship distribution criteria. Here’s a closer look at the most common reasons for 401(k) loans.
The most frequently cited reasons participants took out a 401(k) loan, according to The Current State of 401(k)s: The Employer’s Perspective, from Transamerica Center for Retirement Studies:
- Unplanned major expenses (e.g., home or car repair, etc.) (23%)
- Paying off debt (23%)
- Purchase of a vehicle (11%)
- Home improvements (8%)
- Medical bills (8%).
The other reasons listed include:purchase of primary residence (7%), everyday expenses (6%), tuition (2%), planned repairs to a vehicle (2%) and some other purpose (10%).
[Related: 401(k) Plan Structure Online Course]
The TIAA CREF report Are your employees borrowing from their futures?, reported paying off debt and emergency expenditures as the top two reasons for 401(k) loan usage.
The top reasons for loans have varied slightly over time. In an earlier study, The Availability and Utilization of 401(k) Loans, National Bureau of Economic Research authors analyzed the Survey of Consumer Finances data from 1998 to 2007, concluding the top reasons for loans were:
- Home purchase/improvement
- Vehicles/appliances/other durables.
The authors point out these expenditure categories represent items frequently financed with many types of loans, suggesting that 401(k) loans, at potentially better terms, may be substituting for other sources of credit.
[Related: Certificate Series 401(k) Plans Course, October 13-14, 2017, San Jose, California]
Most plan sponsors believe that having a loan provision as part of their retirement plan is important for their participants, as evidenced by the 87% of plans that permit loans according to T. Rowe Price Reference Point. The percentage of participants with loans dropped to 23.8% in 2016, the lowest since the height of the financial crisis in 2009, when 22.3% of participants had loans outstanding. The average loan balance for participants with loans was $9,037, while the 50-59 age group holds the highest outstanding loan balance.
Stay tuned for more on 401(k) loan tips next month, here on the Word on Benefits.
Jenny Lucey, CEBS
Information/Research Specialist at the International Foundation
