Employers may mean well when they allow employees to take 401(k) loans, and the vast majority of workers with 401(k)s have this option. However, companies are starting to realize that such borrowing is often not in employees’ best interests. As a result, they are beginning to educate them about the long-term effects on retirement of borrowing from their 401(k)s. More important, they're offering alternatives.

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Sometimes It Pays to Borrow From Your 401(k)

The Opportunity Cost of a 401(k) Loan

401(k)s make a tempting borrowing option, because they don’t require you to pass a credit check and the loan interest goes back into the borrower’s retirement account, rather than to a lender. But when employees fail to repay the loans – or when they reduce or eliminate their 401(k) contributions while repaying the loans – 401(k) borrowing becomes much more costly than it appears on the surface. About 20% of workers who have the option to borrow from their 401(k) do so each year, according to the Investment Company Institute.

Consider a 30-year-old employee, Zoe, who borrows $20,000 from her 401(k) to make a down payment on a house. Buying a house is widely considered a smart financial decision and is one of a few reasons to borrow money that even the most conservative financial advisers don’t balk at. (For more, see How to Buy Your First Home: A Step-by-Step Tutorial.)

Assume that when Zoe takes out the $20,000 loan, she has $50,000 in her account. Her interest rate to repay the loan is 4%, but she could have been earning 6% to 8% in the stock market during the repayment period, so she’s coming out behind. Over 35 years she’ll come out $4,075 behind if the stock market returns 6% and $15,000 behind if the stock market returns 8%. And that’s assuming she keeps contributing $250 a month while she repays the loan over 24 months and continues to get a $250 employer match during that time.    

If Zoe stops contributing while repaying the loan (which means no employer match, either), then that same loan ends up costing her a whopping $96,000 over 35 years, assuming just a 6% annual return. (You can check the math on a 401(k) loan you’re considering using the National Center for Policy Analysis 401(k) borrowing calculator.) The 401(k) loan might actually help Zoe if the market happens to decline while the loan is outstanding. But we don’t recommend trying to time the market. (For more, see Sometimes It Pays to Borrow From Your 401(k) and Market Timing Fails as a Money Maker.)

If she doesn’t repay the loan at all, she not only takes principal out of her retirement account; she also misses out on years of investment gains. Plus, Zoe has to pay income tax and a 10% penalty on the $20,000. About 10% of 401(k) borrowers default each year. One reason some employees default is the requirement that a 401(k) loan be repaid within 60 days following a termination or voluntary departure from the company. Employees may not be able to come up with the money to repay the loan on such short notice, especially if they’ve just been laid off. (For more, see Are 401(k) Loans Taxed?)

Why Allow 401(k) Loans at All?

In 2014 the average 401(k) loan balance was $7,780, and the median 401(k) loan balance was $4,239, so most borrowers are suffering lesser financial consequences than the woman in our example. But Americans don’t need to be doing anything to shrink their 401(k) earning potential. The average Vanguard retirement account balance was $102,682 in 2014, while the median Vanguard retirement account balance was just $29,603. The median balance tells us more about the typical American’s account balance, which means most people aren’t on track to comfortably fund their own retirement. 

Current Internal Revenue Service rules say employers can allow plan participants to borrow as much as half of their 401(k) balance or $50,000, whichever is less. But employers don’t have to allow loans at all, and –to prevent employees from using the money frivolously – employers can also limit loan availability to purposes such as paying for medical or educational expenses or buying a first home. They can also stop employees from borrowing any funds the employer has contributed to the account.

The downside of forbidding loans altogether is that employees may be afraid to participate in a 401(k) at all, preferring to keep money they might otherwise contribute in a savings account, where they can access it in case of an emergency. While having emergency savings is a great idea, having too much money in emergency savings is a drag on retirement.

Alternatives Employers Can Offer

That’s where a solution such as the employer-sponsored emergency fund comes in. Companies can help their employees balance long-term and short-term needs by providing for automatic payroll deductions that go into an emergency fund savings account, just as they provide for automatic payroll deductions that go into 401(k)s. (For more, see Why You Absolutely Need an Emergency Fund and How to Use Your Roth IRA as an Emergency Fund.)

A low-cost measure that Home Depot has implemented to reduce 401(k) borrowing is to give employees who apply for a 401(k) loan online a pop-up notice informing them how much the loan could reduce their savings by retirement age. Employers might also educate workers about alternatives that may cost less and avoid jeopardizing their retirement plans, such as home-equity loans. (For more, see Choosing a Home Equity Loan or Line of Credit and Is Taking Out a HELOC Right for You?)

Another solution, according to a survey by Fidelity Investments, is for employers to offer an employee stock purchase plan (ESPP). The brokerage found that employees were less likely to take 401(k) loans, and tended to borrow less if they did take a 401(k) loan, when they also had an ESPP. Employees can sell the stock in the ESPP as an alternative to 401(k) borrowing. This alternative has its own set of considerations, such as the viability of selling stock in a down market and the tax bill associated with the sale – and, of course, employees might be using money they otherwise would have contributed to a 401(k) to purchase their employer’s stock – but it is an option. (For more, see Introduction to Employee Stock Purchase Plans and Selling Employee Stock Purchase Plan Shares.)

Employers can also form a partnership with a third-party company that offers low-cost loans. Through this partnership, employees can repay the loan through payroll deductions, just as they would with a 401(k) loan, but they can borrow without jeopardizing their retirement or incurring a tax bill. One such service is Kashable, a venture-capital and angel-investor-backed startup based in New York City. The company works through employers to provide loans directly to employees at no cost to the employer.

Employers could also require workers who express interest in borrowing from their 401(k) to meet with a financial counselor at the employer’s expense to discuss the loan’s rules and effects as well as possible alternatives. After the counseling session, the employee will be able to make a well-informed decision about whether to proceed with the loan. (For more, see Better Alternatives to 401(k) Loans and 401(k) Loan Pros and Cons.) In addition, employers can cap the number of 401(k) loans taken out during an employee’s lifetime participation in the plan to prevent habitual 401(k) borrowing, and they can require a waiting period between paying off one loan and taking out another.

Finally, employers should consider offering a general employee financial wellness program. Such programs offer free education to employees, paid for by the employer, on topics such as how to get out of and stay out of debt, how to save and invest for retirement, how to create a budget and much more. (For more, see Budgeting Basics tutorial.)

Companies in a variety of industries have taken concrete steps to help employees make better 401(k) loan decisions: Home Depot; South Carolina–based Movement Mortgage; ABG Retirement Plan Services in Peoria, Ill.; and an East Coast grocery and convenience store chain, Redner’s Markets. Employers who want to offer programs of their own can look to these firms for ideas that might be suitable for their own workers.

The Bottom Line

Employers can bolster their workers’ long-term financial security by giving them alternatives to borrowing from a 401(k) and educating them about the full consequences of 401(k) loans. The long-term costs can be far steeper than employees realize.