Now that the Christmas bills are starting to show up in the
mailbox, it’s time to figure out how you’re going to pay them. One possible option is to borrow against your
401(k) retirement plan. Many people do;
and I suspect many more would if they actually read the literature given them
about their 401(k) plan and discovered they could borrow from themselves.
“Borrow from themselves.”
What an appealing idea, and one not totally without merit. The interest rate is lower than at banks or
certainly the credit card company. And
you make the payments to yourself…with interest…right? Isn’t that a way to make us save more? It offers the convenience of payroll
deduction. High interest credit card
debt is avoided.
I’m not sold on the idea, though. It reminds me of words attributed to Franklin
Roosevelt when the U.S.
When I worked at an investment firm, much of my
responsibility involved assisting individuals in managing their account within
their employer’s 401(k) plan. Not all
the plans allowed loans, but many did.
One employer permitted its workers to have as many as three loans
outstanding. I lost count of the number
of its employees with whom I talked who had three loans out. Often they would scrape up (borrow?) the
money to make a couple of extra payments to knock off one loan—and pay FedEx to
deliver us a check overnight. Then they
would call to see if the check had been received and posted and if so, ask me
to process a new loan. They became
agitated if the money had not been posted, or worse, the money had been
received but I had to tell them they could not borrow any more money yet—there
are IRS regulations about how much may be borrowed over a certain period of
time.
But aside from the cycle of debt that this borrowing
encourages, taking a loan from your 401(k) has some other serious pitfalls.
1. Lost opportunity
for growth: That money you took out of your retirement savings to spend on
some depreciating asset, like a car, is not in your account growing. With the stock market in a big upturn, what
you would have earned within your account if the money were still there dwarfs
the measly 5% interest you are paying yourself.
And that 5% is coming out of your pocket; it’s not new money earned on
investments.
2. Lost investment
opportunity: This refers to the fact
that you won’t be able to invest new money into your 401(k) while you are
repaying your loan. The vast majority of people need to put more, not less, money into their retirement account. It might be argued
that if the stock market is in decline then it’s a good thing to have your
money out of the market and in your hands in the form of a loan, meaning point
one above is moot. Fair enough. But say the market is down; stock prices are
low. That’s the time to buy more stock. But instead of putting new money into your
account and purchasing more, cheap shares, you are only making payments and gradually
buying back shares of stock you sold to generate the money that you borrowed.
3. Loan comes due
quicker than planned: It might be a
three-year loan on paper, but if you lose your job next week, that loan
probably has to be paid back in full within 60 days. Otherwise, it becomes fully taxable and might
even be subject to a 10% early withdrawal penalty.
4. Double taxation: The money you save into your 401(k) via
payroll deduction is tax-deferred (we won’t address Roth accounts here),
meaning you won’t pay taxes on that money until you start withdrawing it for
retirement. But if you borrow, say,
$10,000 from that account, your payroll deductions to repay the loan are made
with money that is already taxed. Then
that money is taxed again when you take it out for retirement. If your tax bracket is 25% now and 15% during
retirement, you’ve paid $4000 in taxes on that ten grand. Suddenly that 5% interest rate doesn’t seem
like such a bargain.
These points should give you pause before borrowing from
yourself. If it’s your only option in an
emergency, then consider it. But count
the cost!
Until next time,
Roger
“Be sensible and
store up precious treasures—don’t waste them like a fool.” Proverbs 21:20 CEV
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