In our quarterly Top DC Trends and Developments report, we aim to uncover themes that present opportunities for plan advisors to better address the needs of participants. Our latest edition highlights a trend that warrants advisors’ attention: the increasing use of loans.

Bank of America’s latest Participant Pulse survey revealed that the portion of 401(k) plan participants taking out loans offered by their employer’s plan grew to 2.7% in the second quarter of 2024, up from 2.0% in the first quarter.¹ The average loan amount also increased, from $9,140 in Q1 to $9,311 in Q2.

Separate research from Vanguard Group shows that, overall, 13% of 401(k) participants had loans against their retirement savings at the end of 2023, up from 12% in 2022.²

What’s behind the increase in 401(k) loans? While inflation has eased in recent months, rising costs have led many Americans to fall behind on credit card and student loan payments as they prioritize essential expenses. And with 70% of investors citing persistent inflation as a top concern in our latest Investor Survey, it’s perhaps not surprising that plan participants are seeking to address financial shortfalls and pay off debt.

Under those circumstances, some may consider borrowing from their nest egg the best – or perhaps only – option for fulfilling an immediate cash need. But do plan participants have a good understanding of the risks associated with borrowing against their 401(k)?

Loans versus hardship withdrawals: An important distinction

One area where participant awareness may be lacking is the distinction between retirement plan loans and hardship withdrawals. The latter are only permissible by the Internal Revenue Service (IRS) in specific circumstances of “immediate and heavy financial need” and are limited to the amount necessary to meet that need.³ While participants aren’t required to pay hardship withdrawals back, they are generally taxed as ordinary income, and withdrawals taken before age 59 ½ are subject to a 10% early withdrawal penalty, barring certain IRS exceptions.

Those taxes and penalties don’t apply to 401(k) loans. Most plans allow employees to borrow up to half their balance, or $50,000, whichever is less. That amount must be paid back in full, plus interest, usually within five years.

Given that 401(k) loans are often offered at a lower interest rate than many other types of loans and do not require a credit check or impact one’s credit score, their appeal is understandable. And unlike hardship withdrawals, loans don’t permanently remove money from a participant’s retirement account, although the borrowed assets will miss out on potential market returns while they’re not invested.

These factors generally make loans a better option than withdrawals, but there are still significant risks – especially if the loan can’t be repaid for any reason.

Defaulting on a 401(k) loan will trigger both taxes and the 10% withdrawal penalty for those under age 59 ½. This can be especially problematic if a person unexpectedly loses or decides to leave their job, since most plans will require the balance to be repaid in full within a short timeframe in that case. Employees may also roll the balance over to an IRA or other eligible retirement plan, but again time is of the essence: If they can’t complete the rollover in time, the unpaid balance is considered a distribution.

Furthermore, while the interest paid on the loan can help offset some of the earnings lost while funds are out of the plan, that interest is paid with after-tax dollars. And because participants could also owe income tax on their withdrawals in retirement, the interest payments could take a double tax hit.

Education is key: Conning & Co. tackles serial loan takers

Clearly, there are several important considerations involved in taking a loan from one’s retirement account. If participants aren’t informed about how these factors could impact both their current and future financial situation, they could easily be lured into the trap of thinking a 401(k) loan is “free money” and making an ill-advised decision with potentially long-term negative consequences.

One firm we highlighted in our Top DC Trends report opted to tackle the education issue around participant loans head on. Conning & Co., a global investment management firm, successfully implemented a campaign to decrease the number of participants who perpetually borrow from their 401(k) accounts.

Participants who were identified as “serial loan takers” – those who take another loan soon or immediately after paying off a loan against their 401(k) accounts – were targeted with a simple message to “Think twice before borrowing from your 401(k),” emphasizing the potential drawbacks in doing so.

The number of new loans dropped to nine, down 50% from the 19 loans that were taken the prior year, with the total loan amount decreasing from $443,000 to $224,000.

Exploring other options

In addition to highlighting the potential risks of 401(k) loans, it’s important to inform participants of other short-term debt solutions they can explore as an alternative. This could include encouraging better debt management – ideally through a formal financial wellness program that educates participants on all aspects of budgeting, saving, and planning for retirement.

There are also several solutions that can work alongside a retirement plan to help employers support their employees’ efforts to save for unexpected expenses. Most offer an app that allows employees to see how much they’ve saved and provides quick, easy access to those funds when emergency expenses arise. Employers can also set up automatic payroll deductions that transfer funds to an emergency savings account, or work with a third party that offers low-cost loans that employees can repay through automatic deductions.

It’s worth noting that the most effective way to discourage the use of loans is simply to not allow them. Retirement plans are not required to offer loans to participants, and they can also opt to limit their availability to situations like purchasing a home or paying for medical expenses. Given the risks we’ve just covered – and the many alternative options available – it seems like this could be best solution for plans and participants alike.

Conclusion

As more participants look for ways to pay off debt or cover short-term expenses, 401(k) loans will continue to be a tempting option. And while plan loans can make sense in certain situations, plan advisors should make participants aware of the potential risks so they don’t inadvertently jeopardize their retirement savings.

The Conning & Co. case study demonstrates how impactful education can be in influencing participant behavior. Plan advisors can take a cue from this example and consider ways to educate participants on how plan loans work so they can make informed decisions.

For more retirement industry developments and action items, be sure to check out our latest Top DC Trends and Developments.

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