loan – Memphis Flyer

More retirement plan participants are taking loans from their retirement accounts, and they’re borrowing larger sums of money than in the past. According to data provided by Empower, a retirement plan administrator to 5.3 million accounts, 2.6 percent of participants (approximately 138,000 people) took a loan from their employer-sponsored plan during the third quarter of 2023. This is up from 2.3 percent in the third quarter of 2022 and 1.7 percent in 2020.

Fidelity, the nation’s largest retirement plan administrator, saw a similar increase, with 2.8 percent (641,000 people) requesting loans in the third quarter of 2023, up from 2.4 percent in that quarter of 2022.

The average loan has also increased in recent years. In a survey conducted by Plan Sponsor Council of America, the average 401(k) loan in 2022 was $15,000, up from $10,000 to $11,000 between 2018 and 2021. As of June 2023, the average outstanding loan balance is $8,550.

The popularity of 401(k) loans may be partly due to the fact that 70 percent of retirement plan participants report they don’t have enough in emergency savings to cover six months of expenses. So, it may be that participants are using these loans to pay for unexpected costs.

In the event of a financial crunch, many consider borrowing from their 401(k) because it could be faster and cheaper than other types of credit. However, despite their popularity, 401(k) loans can be highly detrimental to your long-term financial security. Following are five reasons to avoid borrowing from your employer-sponsored retirement account if possible.

1. Long-term savings impact

Perhaps the biggest downside to taking a loan from your 401(k) is that you’ll have less saved for retirement. Taking money from your retirement savings can significantly impact your savings potential over time.

2. Opportunity cost

One of the most significant advantages of contributing to a retirement account is the opportunity for tax-deferred growth and compounding interest. You miss out on this growth opportunity when you remove assets from the account. Even a small loan can significantly impact your long-term savings when accounting for this missed growth opportunity.

3. Double taxation

Contributions to employer-sponsored retirement plans are typically made with pre-tax dollars. You’re then taxed on your assets when you withdraw them in retirement. However, 401(k) loan repayments are made with after-tax money, meaning you need to earn more than you borrowed to repay your loan. In addition, your repayment amount will still be treated as a pre-tax source of income when you withdraw funds in retirement. That means you are paying taxes twice on any loan amount you repay to the plan.

For example, suppose you fall into the 24 percent tax bracket and take a loan from your pre-tax retirement plan. Every dollar you earn to repay your loan is taxed at 24 percent, meaning each dollar is worth only $0.76 after taxes. In order to make your retirement account whole again, you’ll end up paying 24 percent more than what you borrowed (not including interest).

In addition, you don’t get credit for having paid taxes on the loan repayment amount. When you withdraw the funds in retirement, they’re taxed again as ordinary income. If you remain in the 24 percent tax bracket, each dollar you withdraw from the loan repayment is again worth only $0.76. That’s a hefty tax consequence!

4. Missed contributions

Some retirement plans prohibit participants from making regular deferrals while they have an outstanding loan balance. Not only does this restrict the amount you can set aside in retirement savings, but it may also make you ineligible for employer matching contributions. That’s a double hit to your long-term savings.

5. Repayment requirements

If you leave your job for any reason, you’ll have 60 days or until the date you file your next tax return to pay off your outstanding loan balance. If you fail to do so, your outstanding loan balance becomes a taxable distribution subject to ordinary income taxes as well as a potential 10 percent early withdrawal penalty if you haven’t yet reached age 59½. This is another reason to avoid 401(k) loans because if something unexpected occurs you could face these significant taxes and penalties.

Gene Gard, CFA, CFP, CFT-I, is a Partner and Private Wealth Manager with Creative Planning. Creative Planning is one of the nation’s largest Registered Investment Advisory firms providing comprehensive wealth management services to ensure all elements of a client’s financial life are working together, including investments, taxes, estate planning, and risk management. For more information or to request a free, no-obligation consultation, visit CreativePlanning.com.

Julia Greer doesn’t know George Will and doesn’t watch the Sunday-morning news talk shows. But Will, the bow-tied conservative television pundit, author, and columnist, had some harsh words for people like Mrs. Greer last week.

Greer, 67, is one of millions of Americans who took out a home loan they can’t repay. The former grill cook at Baptist Hospital for 35 years lives on Social Security payments of $814 a month. In April, she took out a $50,000 loan to fix up a house in Whitehaven where she plans to care for a cousin who is handicapped from a stroke.

Greer can’t make the monthly payments on the loan, which carries an interest rate of 15 percent and is due in full in September, six months after the loan was made. That’s called a balloon note in the trade.

As Will wrote in a column published in The Commercial Appeal and other newspapers last week, “Every improvident loan requires an improvident borrower to seek and accept it. Furthermore, when there is no penalty for folly … folly proliferates.” By his lights, Julia Greer is the source of her own problem. She borrowed more than she could repay. The stock market took a nasty tumble, and investors from China to Memphis felt the pain because of the improvidence of people like Julia Greer.

But improvidence sometimes has a little help.

Fixing up the house was Greer’s daughter Linda’s idea. A cousin owned the house for several years, and it was paid for but in need of repairs. It is 54 years old and appraised at $96,200. The Greers say the plan was that the cousin would deed the house to Julia Greer so she could get it fixed up, move in, and share living expenses.

Greer tried to get a home-improvement loan from the Teachers Credit Union, First Citizens, and Sun Trust Bank but was turned down for insufficient credit history. A friend recommended she try Home Realty Company and Home Financial in Memphis.

In April, Julia Greer and the cousin met with a closing attorney. The closing costs were $13,000, including a 5 percent “loan origination fee” and another 5 percent “loan discount fee.” On top of that, documents show that Greer was obligated to pay another $2,000 to Home Financial in six months even if she made the balloon payment. The fee would be “waived” if she took out a new loan. Home Realty would keep the balance of the loan, $37,000, in escrow and reimburse Greer for improvements after they were made, if she provided receipts.

When Linda Greer read the closing papers, she thought her mother had been taken advantage of, and she tried to cancel the loan.

“They told me in order to rescind it, I would have to pay the closing amount of $13,000 within 24 hours,” Linda Greer said.

Charles E. Moore of Home Realty said the loan was proper. The closing costs, he said, included payment of back taxes that were due on the property. He was under the impression that Mrs. Greer was going to resell the house after fixing it up and never intended to live in it. The workers she hired, he said, “didn’t have her best interests at heart” so he hired his own workmen to take over.

Moore and the Greers disagree about how much she was supposed to pay each month, but they agree that Julia Greer faced foreclosure unless she got a new loan.

“You can’t stay if you don’t pay,” Moore said.

As it now stands, roughly $19,000 worth of work has been done, and the house is unoccupied. Julia Greer lives in an apartment downtown. Linda said her mother is “scared to death” of losing the house.

Home Realty tried to get Julia Greer to sign for a new loan for $63,000 to pay off the old one. The documents include an apparently forged signature of Julia Greer and list her monthly income as $2,800 a month from a nonexistent drapery business. Linda Greer says her mother “can’t even sew a button.”

Moore said he doesn’t know how that information got in the loan documents.

The Greers contacted Memphis Legal Services and attorney Webb Brewer, who plans to file a lawsuit against Home Realty. Brewer helped write Tennessee’s 2006 Anti-Predatory Lending legislation after seeing scores of working poor people hoodwinked by salesmen peddling subprime loans, debt consolidation loans, and fix-up loans.

“Subprime lending is like a petri dish for predatory lending,” Brewer said.

Or for folly and improvidence. Take your pick.