Borrowing from 401(k) loans is actually okay, study finds

If you ever thought loans would hurt savings behavior, you might want to reconsider.

A research paper conducted by the Wharton Pension Research Council recently found that retirement plan contributions are “remarkably stable” after loans and hardship withdrawals.

Despite some 401(k) plan sponsors who might worry allowing loans from accounts can discourage savings, the findings show that they may not be as bad as thought. And if done right, they can offer a way to help people borrow responsibly. 

Since many 401(k) participants are automatically enrolled and adhere to the default contribution rate with auto-escalation, says Aaron Goodman, economist at Vanguard and co-author of the study, saving behavior tends to follow a steady path over time.

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“Even so, we thought participants who take loans and thereby actively engage with their plans, might be more likely to deviate from or potentially reduce their regular contributions while making loan payments. We found instead that most loan takers do not decrease their contribution rates,” he said in an email.

While he added it’s fair to say that 401(k) loans typically have a small effect on subsequent 401(k) contributions, “an important limitation of our analysis is that we cannot observe participants’ financial behavior outside of their 401(k) plan,” he says.

“If loans cause some participants to decrease their liquid saving or increase their credit card debt, which we do not observe, our analysis might underestimate the drop in total saving.”

However, when it comes to actually borrowing from 401(k) retirement accounts, the implications of such decisions can be complex. That’s why Catherine Valega, founder and president of Green Bee Advisory believes in not having to access any credit in any scenario, especially if one is contemplating leaving the company that hosts the 401(k) plan.

“If you leave the company and that loan is not paid off, it winds up dispersing as a taxable income event to you,” she said.

Goodman added the possibility the employer may also require repaying the entire outstanding balance immediately.

“Any amount that you fail to repay on time, either during employment or after you leave your job is an early distribution, which triggers income taxes and a 10 percent penalty,” he said in an email.

Valega also stresses the importance of having a robust emergency savings fund to avoid the need for 401(k) loans entirely.

Ironically, director of wealth benefits research at Employee Benefit Research Institute (EBRI) Craig Copeland has experienced people contributing to their 401(k) plan, while still funding an emergency savings account.

“Instead of taking a withdrawal or a loan, they may be able to fund that emergency savings account and just take it out of there. That way, they won't need to take the withdrawal because they know that they can still contribute at the same amount, and they can keep their contribution to the emergency savings account,” he says.

While the data may show that participants continue to save at normal rates following a hardship withdrawal, it doesn't capture the downside of borrowing, which is interrupting compounding, says Sean Williams, principal at Cadence Wealth Partners.

“The great Charlie Munger said, "the first rule of compounding is to never interrupt it unnecessarily." While it may be necessary in extraordinary times, it absolutely hurts the investor, even if they pay it back systematically. You can never make up for the lost compounding,” he said in an email.

However, when an individual does have to access their 401(k) and by borrowing from it, Valega notes that “you’re basically borrowing from yourself, which is sort of a nicer way than pulling a line of credit on your credit card, or some other high fee type of debt,” she says.

She sees an opportunity to leverage this behavioral trend to further enhance retirement preparedness, remarking the study “implies that people are paying the loan and they haven't changed the deferral,” she says. “I think that’s a really neat idea.”

Valega asserts that while one of the hardest parts of personal finance is budgeting and cashflow, the study just might end up being a resource to help cope with managing finances.

“They took a loan, and at the end of the day, it's just helping people manage cash flow,” she says. “If we can take advantage of that automation and use it to help our employees save even more, that to me, is really exciting.”