Participants take 401(k) loans for many reasons, but buying a house is among the most common, Jim Sampson, managing principal at Cornerstone Retirement Advisors LLC, told PLANSPONSOR. When the housing market is good, participants are tempted to take a loan against their 401(k) to capitalize on the market, but Sampson said many participants do not think about the consequences.

The big consequence, he said, is that participants must repay loans immediately following termination from their company or risk default. “You basically just locked yourself into an employment contract, indirectly,” he said.

In addition, if the employee is younger than age 59, he or she must repay the entire loan or pay income tax plus a 10% penalty tax on the defaulted amount, according to a paper from the Financial Literacy Center (FLC), “401(k) Loan Defaults: Who Is at Risk and Why?”

FLC conducted research based on information from more than 4.3 million total 401(k) plan participants. Of those participants, about 20% (870,775) had outstanding loans. Of this number, about 12% (103,991, or 2% of the total number of plan participants) terminated their employment with a loan. For this subset, the default rate was high, FLC said—nearly 80% (83,894) of those who terminated employment with a loan subsequently defaulted. This means approximately one in 10 loans resulted in a default.

FLC found that those most susceptible to defaulting loans had smaller 401(k) balances, lower incomes and little non-retirement wealth.

Wells Fargo recently reported that of the participants who take out loans, the greatest percentage are people in their 50s (34.2%), followed by those in their 60s (28.9%) and those in their 40s (27.3%)  (see “WellsFargo Reports Increase in Participant Loans”).

Sampson said that during educational meetings, he makes a point of discouraging 401(k) loans and emphasizes that they can have negative consequences like defaults. “I think we should make it a lot harder for people to take loans on their [401(k)] plans,” he said.

Denise Preece, assistant vice president of field services for OneAmerica, agrees that it’s very easy for participants to borrow from their retirement plans. “So you really have to get to these folks before they go online to request a loan,” she said.

Once participants have reached that point, she said, there’s usually no turning back.

Preece said education about basic finances is key to dissuading participants from taking loans. Participants must be educated about creating a budget, managing debt and simultaneously saving for retirement and a house.

When participants have access to education, they have knowledge before they consider taking a loan, she said. 

According FLC, loan defaults can be reduced by:

•   Limiting borrowers to one loan at a time. Preece said in her experience, many plan sponsors are scaling back the number of loans their plans offer because they think it sends the wrong message about saving for retirement.
•  Allowing participants to repay 401(k) loans even after a job change. FLC researchers caution, however, that this change would likely benefit only participants who begin another job, and would also raise administrative costs and require extra recordkeeping). 
•  Limit the size and scope of loans. The plan sponsor could allow participants to borrow only 25% of their account balances instead of the current 50%.

There is some good news when it comes to loans, depending on how you interpret it: Preece said that according to her company's data, the number of participants requesting a 401(k) loan compared with simply modeling a loan has decreased. OneAmerica’s data could indicate that participants are thinking about loans but ultimately declining them, or trying several scenarios and choosing the best one. "Maybe people aren’t pulling the trigger as fast as they used to," she said. 

On the other hand, Preece acknowledges, this could also be bad news because more participants are modeling loans.