Never borrow from your 401(k)

The ability to borrow from a 401k plan is a pretty standard feature. Originally it was thought that providing some way for participants to access their money before retirement was desirable to encourage participation.

Borrowing from your 401k is never a good idea. A so-called hardship imagewithdrawal is also to be avoided. Here’s why!

1⃣ While you have the borrowed money you are losing growth on that money. Over time this can cost you thousands of dollars in retirement assets. Let’s say your loan interest is the prime rate which is common. That interest rate is currently 3.25%. That’s the earnings on your loan (your money). On the other hand, if the money stayed in the plan, you would likely earn 6-8% or more.

2⃣ You are paying interest on the loan with after-tax money. When you make a withdrawal later in your career you will pay ordinary income tax on the interest you paid to yourself. It’s considered income to the plan and thus to your account

3⃣ You may pay a fee to initiate the loan

4⃣ If you leave your employer before the loan is repaid, you will have a limited period to repay any outstanding balance. If you don’t repay, the balance will be considered a withdrawal. If you are under 59-1/2 you will not only pay regular income tax but also the early withdrawal 10% penalty.

5⃣ While you are repaying a loan you may decrease your 401k contributions thereby further lowering your retirement savings

Your 401k is a retirement plan, a pension plan. It’s not your cash reserve, not your savings account and not your personal ATM. Misuse it and you will pay dearly in retirement. Borrowing from your 401k is like taking home equity loans to maintain a lifestyle and we all know how that turned out.

3 comments

  1. Never have you been more wrong than in this column. I absolutely agree with you that no one should ever take a hardship withdrawal. I also absolutely agree with you that no one should take a loan to “maintain their standard of living”. However, individuals should accumulate everything they can in this fiduciary-managed, employer-sponsored, trusteed savings plan. That is, it is always a good idea to accumulate wealth. Then, taking loans makes a lot of sense – when you are buying a car to commute to work, buying a home to live, paying for the kids college education (or your own).

    You say loans are never a good idea. Never? Compared to what – borrowing from a commercial source? Or are you just saying people should never borrow money?

    1⃣ “While you have the borrowed money you are losing growth on that money.” Not so. You must pay interest to your account on that loan. Are you suggesting that individuals should allocate 100% to equity investments? The loan is simply the part of your assets that are invested in fixed investments – an investment in you, the participant yourself. Fact is, intermetiate term fixed investments have not achieved 3.25% in recent years due to the Fed’s market interventions. And, of course, those who had a loan in place in 2008 probably did better than those who were fully invested in equities. Simple rule – rebalance your account after the loan as necessary to hit your target allocation – whatever that may be.

    2⃣ “You are paying interest on the loan with after-tax money. When you make a withdrawal later in your career you will pay ordinary income tax on the interest you paid to yourself.” Yes, the monies are “after-tax”, but if the loan is secured with a mortgage, it may be tax deductible. Further, if the underlying principal was Roth 401(k) dollars, the earnings, when paid from the plan are tax free. When you pay interest on a commercial loan, it is also with after tax money that you will never see again.

    3⃣ “You may pay a fee to initiate the loan.” There are no fees on commercial loans?

    4⃣ “If you leave your employer before the loan is repaid, you will have a limited period to repay any outstanding balance. If you don’t repay, the balance will be considered a withdrawal. If you are under 59-1/2 you will not only pay regular income tax but also the early withdrawal 10% penalty.” Why are you apologizing for inadequacies of the recordkeepers? My 401(k) plan not only allows me to continue repayment post-separation, but they actually allow me to initiate a loan after separation and repay with 21st Century Electronic Banking (ACH).

    5⃣ “While you are repaying a loan you may decrease your 401k contributions thereby further lowering your retirement savings.” So, people who take commercial loans don’t reduce their contributions?

    Here are the facts:
    1. Other than employer-sponsored retirement savings plans – surveys show people spend everything they take home (and sometimes more) – See the American Payroll Association’s annual survey – Getting Paid in America
    2. If you limit access by precluding loans and withdrawals, people will only save what they believe they can afford to earmark for retirement – which will leave almost everyone unprepared for retirement upon reaching retirement age.
    3. Eliminating hardship withdrawals should be accompanied by taking the loan program into the 21st century – that is eliminating hardship withdrawals does not violate IRC 411(d)(6) anti-cutback rules.
    4. You want to build wealth among the middle class? This is basically the only options available to Americans in the private sector. Make sure they have access to a 401(k). Make sure that they know the 401(k) is their account – and that the 401(k) is a separate legal entity, managed by fiduciaries within a trust agreement. Make sure that they know they can continue participation until death. Make sure they know who benefits and who loses from financial and investment decisions. that they can continue to participate in for life – so that they know who benefits and who loses from decisions (the individual participant). 5. Once they know it is the “Bank of Jack” or the “Bank of Dick”, and that they have reasonable access via the loan provision (prior to and after separation), they are free to save everything they can into the employer-sponsored 401(k). The result: They save, get the match, accumulate assets, borrow as needed to meet an immediate need (borrow from the “Bank of Dick” versus a commercial source, which would typically charging a higher interest rate), reallocate/rebalance investments as necessary, continue contributions and getting the employer match, repay the loan, rebuild the account for a future, larger need. Repeat as necessary, up to and through retirement.
    6. In my 401(k) plan, 1.4B of the 4.7B belongs to 15,000 or so former employees who have decided to leave money in the plan post separation (including me, representing a lifetime of savings).

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    1. Your views are counter to every piece of advice I can find on this subject. What is the difference why one takes a loan, the adverse consequences are the same. The 401k is for building future retirement income and nothing less. I think you attach too much sophistication to the average plan participant. They borrow money for all sorts of inappropriate purposes so the message not to borrow period, is appropriate in my view. Your point #2 is the same logic I expressed. However, I don’t think we ever have proved that. Nevertheless, having loans available to mitigate the fear of not having access does not mean it should exercised. Presenting the 401k and its purpose needs to be kept simple and focused on its purpose. As an aside, most financial advisors would also say don’t leave money in your former employers plan roll it over. I disagree with that for similar reasons. That is keep it simple for the average person who if they do take it upon separation will likely mismanage it.

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      1. You state that my views are counter to every piece of advice you can find on this subject. That is certainly true if all you read is the prattle of service providers – and, their parrots in the media, such as the article in today’s Wall Street Journal. Keep listening to the record-keepers and see how far that gets you – those who are often singularly focused on their revenue (fees on assets under management) – not on worker financial success.

        Want a more balanced review – try:
        Federal Reserve Bank of New York at: http://www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf
        Where they concluded people could have substantially benefited from 401(k) loans, however, those most in need tended to avoid taking such loans: “… We estimate that households with access to 401(k) loans could have saved about $3.3 billion in 2004—about $200 per household — by shifting debt to 401(k) loans. We find that liquidity constrained households are most likely to borrow against their accounts; however, the fastest growth has been among higher income, less liquidity constrained households. “

        Or:
        Wharton & Vanguard at: http://www.asppa.org/Portals/2/PDFs/White%20Papers/WP2014-01.pdf
        Where they concluded: “… fully 90 percent of loans are repaid in a timely way … Prior research has suggested that the availability of such a loan feature encourages higher retirement contributions by improving the liquidity of a tax-deferred retirement account. … we estimate one in 10 loans is not repaid—failure to repay typically occurs when the worker leaves his current employer … we find that liquidity-constrained participants, those with lower income and lower non-retirement wealth, are more likely to borrow from their 401(k) accounts. … 86 percent of the workers terminating with a loan do default. Low-liquidity households are more likely to default, although the effects are economically small compared to the mean default rate. … This paper also provides a revised estimate of $6 billion annually in national 401(k) loan defaults … our figure for loan defaults is an order of magnitude lower than retirement plan leakage due to account cash-outs upon job change, which the GAO (2009) reported at $74 billion in 2006.”

        And, while not part of the Wharton/Vanguard study, in fact, much of the loan defaults would have been cashouts upon job change – even if no loan were in place.

        You’re wrong on the “singular” purpose of the 401(k). The 401(k), as a voluntary, defined contribution plan, requires consistent saving over 10, 20, 30 or 40 years to be successful. So, it is most effective when marketed as an opportunity to accumulate wealth – to become a “middle class millionaire”. Marketing it as an opportunity to create a “successful retirement 40 years in the future”, doesn’t exactly have the same cache. It won’t prompt the higher level of savings necessary for most workers, and it is why so many employers have migrated to incorporate auto features.

        Simply, if you want people to prepare for retirement, they need to save more. Most middle-class American’s won’t if you restrict accruals to post-retirement income replacement. That’s because many, perhaps most Americans, live paycheck to paycheck. Consider the survey by the American Payroll Association that I mentioned before. The survey was given to approximately 26,700 individuals. The question was: How difficult would it be to meet your current financial obligations if your next paycheck were delayed for a week?

        Very difficult 30.5% 8,135 responses
        Difficult 35.3% 9,397 responses

        So, given the superior accumulation capability of the 401(k), the fiduciary protections, the use of a trust, etc., all of these features put middle-class working Americans in the position to leverage access to that tool – not only in terms of saving for retirement, but in terms of saving along the way to retirement. It is just because they are NOT savvy that using the “Bank of Dick” concept is so effective. This is their money. They had to first save. They had to first deny themselves current consumption in favor of some future financial need. They have to “pay themselves first”. Otherwise, too many people only save what is left at the end of the month, after all the bills are paid. Trouble is, what is often left at the end of the month is not money for savings, but more bills.

        Limiting 401(k) savings only to those assets targeted for retirement will only ensure that many, perhaps most middle-class Americans will arrive at retirement age financially unprepared. Remember that 90+% of all loans are repaid while individuals remain actively employed. The loan defaults are ~86% of those loans that are outstanding at separation.

        Most defaults are < $5,000 and would likely have occurred anyway as individuals with small account balances, tend all too frequently to cash out when changing jobs. That is, people who only save what they can afford to earmark to retirement tend to save less. Similarly, many studies show that once the account balance exceeds $20,000 or so, the tendency to take distributions when changing jobs declines significantly. Otherwise, a small account balance is almost irresistible to meet short term needs when people change jobs. So, the goal should be to build the account quickly, which is consistent with saving to meet short term needs. As EBRI confirms, average tenure has not changed significantly over the last 40+ years – averaging between 5 – 6 years. So, we are talking about 5, 6, 7, 8 or more employers in a typical worker’s career – and plenty of opportunity for leakage if the account is solely for retirement.

        Bottom line, until service providers join the 21st Century, and offer electronic banking capability, we won’t see a substantial reduction in loan defaults post-separation. Until plan sponsors get with the program and eliminate hardship withdrawals, in favor of loans and 21st Century banking, we will continue to see substantial pre-retirement leakage. And, until the default at separation is not payout paperwork but confirmation that participation continues unchanged (except for the ability to make 401(k) contributions from wages), including the ability to initiate and repay loans, we will continue to see substantial leakage at separation – whether or not a loan is outstanding.

        Let’s solve the problem. Let's get people to accumulate more wealth. Let’s avoid repeating the prattle of service providers who appear to be more concerned about their fee income than they are worker wealth accumulation.

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