Nearly A Quarter of Fidelity’s 401(k) Accounts Have Loans Against Them. Why This Is A Bad Idea.

A while back I wrote an article about 401k loans and taking early withdrawals from your retirement account.  I talked about the penalties you could face, and explained why I think it’s a bad idea.

This week I was reading some economic news and came upon an article on Reuters.com that gives a startling statistic – that nearly a quarter of Fidelity’s 401(k) accounts have a loan against them.

A record number of U.S. workers are tapping into their retirement accounts to make it through the economic downturn, Fidelity Investments found in a survey released on Friday.

Among the 11 million workers whose 401(k) plans are run by Fidelity, 11 percent took out a loan from their plan during the 12 months ended June 30, the company said, up from 9 percent at the same point a year earlier.

By the end of the second quarter, plan participants with loans outstanding against their 401(k) accounts had reached 22 percent versus 20 percent a year earlier.

To me it’s crazy that of the 11 million 401(k) plans being run by Fidelity, almost 2.5 million of them have outstanding loans.  Do all these people realize the penalties they could face if they lose their job and have to repay it immediately?  Or is this just a sign that times are tough, and a continuing indicator that people aren’t planning ahead for emergencies, and are living in the now?

During the quarter, 2.2 pct of Fidelity’s active 401(k) participants took a hardship withdrawal, up from 2 percent a year earlier, and another peak, Fidelity said.

Often those withdrawals were used to prevent foreclosure on a home or pay college tuition.

“People have been looking to their 401(k) plans as a source of relief to help them meet financial hardships,” said Beth McHugh, a Fidelity vice president who oversees the area. “For many individuals that is their primary savings vehicle.”

Loans and withdrawals were highest among workers between 35 to 55 years old, Fidelity found, peak earnings years.

So more people  are taking out loans and hardship withdrawals from their 401(k) than ever before.

Fidelity found signs of continued thrift in the workforce. The average percentage of salary saved in a 401(k) held steady at 8 percent, similar to the rate in the first quarter, while 32 percent saved 10 percent or more of their pay.

But the rising rates of loans and withdrawals show more people have turned to their savings to cover basic expenses, McHugh said. She added that second-quarter rates tend to be higher as parents look for ways to cover college tuition.

The good news is that they do see people continuing to save money in their 401(k), but in the end many of them are turning to their retirement accounts to cover even the basics – and many of them are actually taking 401k loans out to pay for their child’s education.  I’d argue that this is a mistake. The child can always take out a loan, get scholarships or do other things to help pay for their own education.  But short circuiting your retirement and possible gains by reducing your balance could hurt your later on – you can’t replace those gains and the compounding interest later on!

Why Taking Out A 401k Loan Is A Bad Idea

When taking out a 401k loan, usually you can borrow up to 50% of your vested account balance or $50,000, whichever is less. In most circumstances you have a maximum of five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback.

I’ve written about it more than once on this site, but I think taking out 401k loans is usually a bad idea – only to be done in the worst of circumstances.  Unfortunately too many people are using them to just pay off debt, buy a new car, or pay for other wants or needs, instead of taking out a loan with their local bank. Why not pay theirselves interest instead of the bank?  There are quite a few good reasons why not.

• You May Have To Repay Your 401k Loan Immediately If You Move Jobs Or Are Fired:  One thing people don’t consider in this unsure environment is that they could lose their job and end up having to pay back their 401k loan immediately – when they can least afford to.   Many plans offer a 60-90 day grace period to repay the loan, but is that really enough on a large loan of thousands of dollars?
• Subject To Taxes And Penalties If Not Repaid In Time: If the loan isn’t repaid, there will be a 10% penalty, and federal and state taxes are taken out as well.
• If Your Stocks Are Currently Down, You Short Circuit Possibility Of Regaining Stock Value:  If you withdrew your money when the market was down, you won’t be able to regain those losses when the market goes back up.

For many people if they find themselves in a situation where they have to repay a loan, and they don’t have the money, they may be better off taking out a loan at a bank to repay the loan – and avoid those penalties and taxes.   And because they have to take out a loan with most likely end up paying a higher interest rate.

So what do you think about the high rate of 401k loans, and early withdrawals?  Do you think they represent a good opportunity to pay yourself interest, or are the risks associated with them too high?  Would you take out a 401k loan to pay for your child’s education?  Tell us your thoughts in the comments.