It’s awfully tempting. You see that money in your 401k plan account just sitting there. And you think of all the possible uses for it. Why not take a loan? You will pay it back — with interest!
Generally, that is a really bad idea to take 401k loans. Here are the reasons why.
You will likely forfeit some company matching contributions
Many individuals who take 401k loans end up stopping or lowering their contributions while they are paying back their loans. This often results in the loss of 401k matching contributions when their contribution rates fall below the maximum matched percentage.
There is no better investment you can make than receiving free money in the form of company matching contributions. It is the safest, easiest way to earn 25%, 50% or 100% — depending upon your company’s matching percentage.
Job changes can force defaults of 401k loans
Most individuals considering a job change don’t realize that their outstanding 401k loan balance becomes due when they leave their employer. In the case of an involuntary job loss, an outstanding 401k loan can add significant pain to an already difficult situation.
Regardless of whether a job change is voluntary or involuntary, few of us have the financial resources available to immediately pay back a 401k loan if we leave our employer. As a result, most of us are forced to default.
Studies have shown that 86% of individuals who have an outstanding loan when they leave their employer for a new job will default on that loan. The defaulted balance becomes subject to state and federal taxes and possibly state and federal early withdrawal penalty taxes.
Plan balances that leave 401k plans due to loan defaults are rarely restored making it less likely that loan defaulters will build adequate retirement savings.
Studies indicate that participants under 30 who experience a loan default (which is treated as a hardship withdrawal for tax purposes) end up reducing their final retirement balance by an average of 20%. That’s a lot!
The opportunity costs can be substantial
When you take a participant loan, it becomes one of your investments in your 401k plan account. Assume that you take a $10,000 loan for five years at a 6% interest rate. That portion of your 401k balance will earn a 6% return for five years.
Had your loan balance been invested in one of the other investment options in your plan, you may have earned a lot more. For example, the five-year return on the Schwab S&P 500 Index Fund through September 30, 2018, was nearly 14%. That’s more than twice as much!
Interest on a 401k loan is not tax-deductible
Anyone needing a loan should investigate the possibility of taking a home equity loan first, because interest on those loans is tax-deductible.
Although interest deductibility on home equity loans has been limited by tax law changes, you may still be able to deduct interest payments, depending upon the loan’s purpose. It is worth checking.
Paying interest to yourself is not a good idea
I have heard many participants say they believe 401k loans make sense because they are paying interest to themselves. They often add that the higher the interest rate, the better!
First, it is normally not a desirable financial strategy to pay interest of any kind. Second, why would you want to pay a higher interest rate on a loan just because you are paying interest to yourself? That just means you have less of a paycheck to live on.
Easy access can lead to bad loans
Can’t get a loan from anywhere else? Yes, you can still get a 401k plan loan. There is no underwriting. While this may seem like something that is working in your favor, it actually is not.
Easy access to a 401k loan can often make your bad financial situation worse, pushing you into bankruptcy and/or resulting in the loss of your home. If a bank won’t give you a loan because you are falling short on the income requirement, it is probably not a good idea to take a loan from your 401k plan.
Your 401k plan account balance is protected in the event you declare bankruptcy. Creditors cannot get at your account balance if you need to get a fresh start by declaring bankruptcy. However, if you have an outstanding 401k loan, you may end up defaulting on it if you are forced to go through bankruptcy.
Double taxes are paid on interest payments
The interest you pay on 401k loans is double taxed. Since loan payments are made on an after-tax basis, interest on each payroll loan payment is taxed first then and taxed for a second time when paid out to you as a distribution at your retirement.
Many 401k plan participants say to me, “Bob, if taking 401k loans is so bad, why would the company let me do it?” Good question! I believe that 401k loans should be eliminated as an option from all 401k plans.
It is clear that 401k loans can drastically reduce your chances of achieving retirement readiness. In addition, they are one of the worst investments you can make in your 401k account.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, 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.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly a half billion dollars 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 https://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, a 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.