This Common Retirement Mistake is Putting Thousands of Workers in Jeopardy

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When it comes to retirement, it sometimes seems like it's a case of one step forward, one step back. That's made clear by a recent report from Fidelity that sheds some light on our changing savings behavior.

In one regard, we're doing better. Retirement account balances have reached record highs. The average 401k balance is more than $90,000. The average IRA balance is nearly $95,000. And the average 401k balance for those who have contributed for 10 years is roughly $250,000.

What's driving these record numbers? Investor behavior, largely. Fidelity reports that more than one million workers raised their retirement contribution in the first quarter of 2015.  Average contributions are also at record highs.

This is all good news. Yet not everything is so rosy. Despite these elevated savings numbers, the majority of us still aren't saving nearly enough.

Many people cringe at the conventional wisdom that says you need at least $1 million for retirement. Sadly, a $1 million estimate may be conservative. A recent investor survey by Legg Mason suggests investors may need double that number to feel comfortable.

Here's something even more problematic. Despite record retirement savings, more and more people are making a serious mistake that can put their retirement in jeopardy -- misguided use of their retirement account loan option.

The increasing popularity of the 401k loan

Tapping a 401k for short-term spending needs has long been frowned upon by experts. Loans and withdrawals often come with penalties attached. Plus, there's serious opportunity cost involved. Money you take out today is money that should be generating returns.

Data from Fidelity shows the average 401k loan balance has reached a record high of nearly $10,000. Additionally, one in five 401k holders has an active loan. That means loans are becoming more frequent in number -- and more expensive. 

One reason for the increase in loans may be the general increase in savings. As people save more, they grow confident. They feel like there's time to make up for lost ground.

Yet that's a recipe for reduced long-term investment growth. It also sets a dangerous precedent that can negatively affect saving behavior. Having to pay back a 401k loan is a financial burden. It reduces the amount of money available to save, which has an impact on behavior. Fidelity found that 40-percent of those who take out a 401k loan reduce their savings rate within five years.

It's important to realize, however, that retirement loans aren't always a bad thing. Occasionally, they're actually the most efficient option.

The key is learning to make that distinction.

Action Plan: Navigating the retirement account loan minefield

Increasing your savings rate is a great idea. Taking out a retirement account loan, however, should only be pursued under certain circumstances. After all, most of us aren't saving enough money, so pulling more cash out isn't always a smart idea. 

Let's review what you need to know.

  • Have you exhausted your emergency fund? Are you preparing to take a 401k loan because you feel it's your only choice? Pause and think through your options. Have you thought about a home equity loan? A personal loan from family or friends? Negotiating with creditors? All avenues should be explored before moving ahead.
  • Are you secure in your job? Many plans require the entire loan balance be repaid shortly after you switch jobs. If you're preparing to switch companies, or fear your job may be insecure, this is not the time for a loan.
  • Crunch the numbers. Before taking out a loan, spend a few minutes with an online calculator to see how much return growth you're foregoing. 
  • Stick to your repayment schedule. If handled properly, a 401k loan can have minimal negative effect on your retirement savings. Pay back the loan quickly and on time. 
  • A 401k loan does offer some clear advantages over other forms of loans. There is no credit check or application process. Fees are minimal. You can receive the money in as little as a few days. Repayment terms are flexible.
  • Pulling money out of your 401k in a roaring bull market can cost you serious money. Yet a 401k loan can actually have positive effects in a bear market, as your money is no longer exposed. This means 401k loans should, ideally, be taken out during down markets. 

Retirement account loans are a tool. Used correctly, they offer significant benefits. Yet far too many of us use these loans in a suboptimal fashion. If you're considering taking a loan from your account, think about the full range of variables before making your decision.

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