The second in our series on how to manage your 401(k).
At first glance, 401(k) loans look like a good idea. “I need money so why not borrow from myself?” No paying interest to a bank, no application hassles, I probably won't turn myself down for a loan... What could go wrong? Actually, next only to not saving anything, borrowing money from your 401(k) is the surest way to insure that you will not have enough to retire.
If you’re considering a 401(k) loan here’s a rundown of the rules:
1. Can borrow up to $50,000 or 50% of vested balance, whichever is less (IRS Rule).
2. Must be paid back in no longer than 5 years (IRS Rule).
3. Interest rate is usually the current prime rate or prime plus 1 or 2 (set by plan).
4. Must be paid back with after tax dollars (loan repayments are deducted from payroll after payroll taxes)(IRS Rule)
5. Full payment due on termination of employment (IRS Rule)
6. Failure to repay on time or at termination results in loan balance being declared a distribution. If distribution occurs before age 59 ½, it is subject to income tax plus 10% penalty (IRS Rule).
7. Loan fees – Typically a loan origination fee and an annual loan maintenance fee. Fees usually range from $50 to $100 (set by plan vendor).
8. Minimum loan usually $1,000 (set by plan vendor)
401(k) participant borrowing is very common. A recent Fidelity Study found that out of the 12.3 million employees in Fidelity plans, one out of every five 401(k) plan participants has a loan outstanding, and one in nine took a new loan in the past year, with an average loan amount of $9,000. More telling is that Fidelity found that half of all borrowers take out more than one loan, and that the likelihood of taking a hardship withdrawal rises dramatically among multiple borrowers (climbing steadily from 6% for those who have taken one loan to 27% for those who have taken 7 loans).
Borrowing from your 401(k) is a very bad idea, here’s why:
1. Many loans never get paid back. A recent study by the Brookings Institution revealed that in 2012, 17.4% of 401(k) loans defaulted resulting in the loss of $37 Billion from the nation’s retirement pool and the subsequent taxation of these funds. At an average tax rate of 20% that’s a tax bill of $7.4 Billion. If you don’t pay back your 401(k) loan, you now have a much reduced retirement fund and a big fat tax bill to boot. However, Uncle Sam thanks you for your contribution to help reduce the federal deficit.
2. 401(k) loans are more expensive than it would appear. The interest rate (at the prime rate or prime plus one or two) may look tame but consider that the funds must be paid back plus interest using payroll deduction and you don’t get that nifty tax break that you get with 401(k) contributions. The government is going to take its cut upfront on loan payments so that loan is going to cost more, and the higher your tax rate, the more you will pay. In addition, at retirement, when you take the money out that went to pay the principal and interest on the loan, it gets taxed again so whatever the tax effect of the loan, it has now doubled. Add the loan fees that the plan vendor charges and you now have a very expensive loan and will have a lot less money at retirement.
3. Even though the rate that you pay yourself on the funds you borrow will be competitive with other fixed income investments because it will be at least the prime interest rate, it may not be as much as you would have gotten by being invested in either stock or bond mutual funds. If you would have borrowed money from your 401(k) in the depths of the Great Recession in 2008 you would have paid yourself a very low interest rate but you would have also missed out on the second greatest bull market in history. For example if you took out a loan in 2008, the prime rate was around 5%. However a solid, cheap balanced mutual fund like Vanguard Star would have returned 17% annualized over the same five year period. So a hypothetical $10,000 loan would have ultimately cost you $7,623 plus interest and the taxes on the funds used to pay it back.
4. 401(k) funds are generally sheltered from creditors in a bankruptcy proceeding. If you borrow the funds out, you may have used one of the few assets that you have that enjoys that protection.
5. The Fidelity study mentioned above found that once a participant takes out a 401(k) loan; they are much more likely to take out another… and another. Fidelity found that half of all borrowers take more than one loan. We humans are very prone to serial behavior, once we do something, it becomes easier for us to do it again… and again… and again, even if it’s not in our best interest. Thus our retirement stash becomes an attractive source of funds for everything but it was intended.
6. Almost all 401(k) participants who take 401(k) loans either stop contributing to the plan while making loan payments or sharply reduce their contributions. Many also lose the company match by doing so. The loss of these two sources of contributions will sharply reduce the amount that they will have for retirement.
To avoid tapping into our 401(k) plan using loans, make setting up an emergency fund a top priority. Most people should have six months of expenses saved in a highly liquid account for emergencies. If this is insufficient for your financial need, explore all other sources of loans first. More attractive alternatives include a home equity loan (if you have equity in your home) or loans from family. Avoid taking loans from your 401(k) plan except under the most desperate circumstances. One final note, of all the reasons people borrow from their 401(k), paying for children’s college is by far the most popular. This is an extremely bad idea. Sure, we all don’t want our children burdened with debt, but the cold hard truth is that all kinds of people will lend your kids money for college but no one… let me repeat that… no one is going to lend you money to retire.