The Hazards of 401(k) Loans!

Jun 1, 2015

If you need money, should you consider borrowing from your 401(k)?  It may be the easiest place to get needed funds, but is the impact on your future retirement lifestyle worth it?  

401(k) plans are allowed, though not required, to offer participants the “opportunity” to take a loan out of their account.  While this borrowing privilege can provide a nice safety net in an emergency, using this option as easy access to money for non-emergency needs can leave a hole in your retirement savings.

How Does It Work?

For those that allow loans, a 401(k) plan enables a participant to withdraw the lesser of $50,000 or 50% of the 401(k) account balance. The money is withdrawn in a lump sum and is raised by selling investments in the 401(k) account.  The loan is then paid back on a 5-year amortization schedule based on a calculated interest rate.  If the loan is for the purchase of a principal residence, the pay back period can be adjusted to longer than five years.  Once the loan is established, the participant begins immediately to make loan payments to their 401(k) plan via their paycheck.

People who like 401(k) loans talk about paying interest to themselves versus to a lending institution.  While this may be true, it is still akin to robbing Peter to pay Paul.  You are just moving this “interest” from one source of funds (your paycheck) back to your 401(k), with the result being a reduced cash flow from your paycheck and, more often than not, a reduction in your 401(k) contributions.  Another consequence is the income tax impact.  Generally, the contribution to a 401(k) is pre-tax; however, the loan repayment to the 401(k) is made with after tax dollars.  This can result in lost income tax benefits.


401(k) Loan Example

Periodically, JPMorgan updates a presentation called “Guide to Retirement” that covers important topics to investors.  One topic is the impact that loans from 401(k) plans can have on participant balances.

Their analysis looks at two 401(k) participants that begin contributing 6% of their salary at age 25 when they are earning $30,000. Their employer matches 3% of their salary.  Their contribution level stays at 6% of salary, but their salary increases 2.25% each year, resulting in an increased dollar amount being contributed each year.  

The only difference between the two participants is that one person takes no loans and the second person takes two loans for a total of $20,000 and a pre-retirement distribution.  The first loan is $10,000 to buy a house at age 32.  The second loan is $10,000 for a child’s college expenses at age 50 and a distribution for $10,000 is taken at age 62 to cover an unknown need.  

In this example, when the participant borrows money, the loan is repaid by eliminating the contribution during the payback period, which also eliminates the employer match.  The funds in each 401(k) account are invested 60% in the S&P 500 and 40% in the Barclays Aggregate Bond Index for the forty-year period from 1974 to 2014.

Long Term Impact on Retirement

The participant who never borrowed money had a 401(k) account worth about $1.7 million at age 65.  The second participant who took out a total of $20,000 in loans plus a $10,000 distribution, retired with a 401(k) account only worth about $1.3 million.  A difference of $400,000!

Why the Significant Impact?

There are three key reasons why the impact is so great:

  • The borrower loses ground when his/her contributions are reduced in order to repay the loans.

  • The borrower foregoes the employer match, which is essentially free money.

  • The loan itself comes from investments that could otherwise be growing within the 401(k).

Summary

401(k) loans are often obtained without many hoops to jump through and no credit reports to review, so they can be easier to get.  Before you move forward, give serious consideration to your other options, including not borrowing money but rather saving for your upcoming need.  After all, if you can avoid touching this retirement nest egg, your retirement lifestyle will have a better chance of meeting your expectations.

Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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