By Robert C. Lawton, AIF, CRPS, President, Lawton Retirement Plan Consultants, LLC
Taking a participant loan from a 401k plan is such a bad investment choice that it should not be allowed in any 401k plan other than for hardship reasons. Here’s why 401k plan loans are the worst investment anyone could possibly make:
Why A 401k Loan Is The Worst Investment
The interest on a 401k loan is not tax deductible
Anyone needing a loan should investigate the possibility of taking a home equity loan first, since interest on these loans is tax-deductible.
Paying interest to yourself is not a good idea
I have heard many participants say that they believe a plan loan makes sense because they are paying interest to themselves. They often add that the higher the interest rate, the better! First, it is never a desirable financial strategy to pay interest. Second, the interest rate paid on participant loans may or may not be competitive with the rate on a home equity loan. Third, paying yourself more interest only means that you have less of a paycheck left to live on.
Participant loans are double-taxed
This is a real killer and one of the major reasons taking a 401k loan is the worst investment option. All participant loan payments are made using after-tax dollars and that is the first time that a participant loan balance is taxed. Assuming the loan is completely repaid, the second time the balance is taxed is when funds are removed from the 401k plan and used to fund a retirement.
The opportunity cost can be substantial
Assume that a participant takes a $10,000 loan for 5 years at 6%. The investment experience on that portion of the participant’s balance will be a 6% return for 5 years. Had the loan balance been invested in the investment options in the plan for the same period of time, the participant may have earned twice as much or more!
Many participants default on their plan loans
A large percentage of participants who take loans never pay them back. This “leakage” from their retirement accounts substantially reduces participant final balances.
Most plan sponsors can’t say no
Unless the plan has hardship provisions attached to its loan provisions, a plan sponsor cannot deny a participant loan request. This makes the 401k plan the lender of last resort and results in many bad loans being made.
It is clear that participant loans can drastically reduce an employee’s chances of achieving retirement readiness and is without question the worst investment anyone could make. As a result, plan sponsors should seriously consider limiting loan availability to hardship criteria or eliminating loans entirely from their plans.
About the Author
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton has over 30 years of retirement plan consulting and administration experience and has provided consulting services to many Fortune 500 companies including: Aon Hewitt, Apple Inc., AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Car Company, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
About Lawton Retirement Plan Consultants, LLC
Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at: http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.