Pretty strong words. Some planners these days even go so far as to say 401(k) loans amount to little more than an act of sabotage perpetrated against your future self. Yikes…that just can’t ever be good, right? But if borrowing against a 401(k) plan is so universally regarded as detrimental by many experts, we can’t help but wonder why the practice is even legal.
To get to the bottom, we decided to do some digging on our own. So, let's conduct a little myth busting exercise. We'll expose the charges leveled against 401(k) loans to stiff cross examination and see if the allegations hold up.
Myth #1: A 401(k) Loan Shrinks Your Account
OK, this is technically true but c’mon. A 401(k) loan temporarily distributes assets from your account and, like any distribution, immediately reduces the value of your account. But if we are going to get technical here, a 401(k) loan really isn’t a “loan” either. At least not in the sense of a traditional credit instrument. A 401(k) loan just moves your own money from one pocket to another. Money where taxes are deferred and money you get to replace with interest over time. While rules vary from plan to plan, nearly all 401(k) plans that permit loans apply interest charges calculated at Prime Rate plus 1% or 2% on the outstanding loan balance. With the prime currently holding at 5.5%, that means an earnings rate of 6.5% or 7.5%.
The principal basis for the “shrink your account” claim is grounded in the idea that 401(k) loans rob investors of the opportunity to fully invest retirement savings in the common stock mutual funds their plans offer. Historically, common stocks yield higher long-term annual returns than any other investment option made available by a plan sponsor. It’s important to remember that common stocks are more volatile from one year to the next and don’t increase at a constant annual rate (despite enjoying higher average rates of return over time). This means performance will undoubtedly lag fixed rate investments for some intervals when stocks prices contract (think 1929-33, 1981-82, 2000-03, or 2007-09). Exactly when those periods of time will occur and how long they will persist is impossible to know in advance. So, whether a 401(k) loan shrinks your account depends entirely on the relative performance of the loan earning prime plus 1% or 2% vs. the hypothetical alternative investment choices you could have made over the period which the loan is repaid.
Verdict: Mostly False
Myth #2: A 401(k) Loan Carries Risk
Let’s start with the basics. All tax deferred retirement savings plans, including 401(k) plans, 403(b) plans, IRAs, etc. are governed by strict rules designed to encourage retirement savings and discourage early withdrawals. Under these rules, distributions are always taxable as ordinary income in the year received and nearly all distributions prior to age 59 ½ are subject to a 10% early withdrawal penalty on top of any regular income tax owed. The incremental risk that accompanies a 401(k) loan is found in the fact that should a worker lose his or her job or move to a new employer, outstanding 401(k) loans must be repaid prior to filing your next tax return. Failure to do so results in reclassification of a “loan” to a “distribution.” And distributions trigger taxes. If you are in a long-term stable employment situation, the fears of unexpected job loss are probably overstated. If you plan to change jobs however, it’s a different story.
Another incremental risk accompanying a 401(k) loan is that you stop saving for retirement while you pay back the loan. You can borrow up to 50% of the vested balance in your account up to a maximum of $50,000 and most plans let you repay the loan through payroll deduction. If your take-home pay stays about the same after taking out a loan and starting the repayment process, it’s a good indication your retirement savings program has been put on hold. That’s a mistake. Before taking a loan, include the monthly loan repayment costs in addition to your existing 401(k) contributions (or even regular taxable savings) in your new budget. This keeps you honest with your future self; a future self that is entirely dependent on your current self to determinedly accumulate a large pool of retirement savings.
Myth #3: A 401(k) Loan Taxes You Twice
While there is a kernel of truth buried in this allegation, the reflexive fear triggered by the dreaded charge of “double taxation” is way overblown. Here’s how it works. The amount of money you borrow is never taxed twice…but the interest you pay on the loan is. That’s because tax law requires you to pay yourself interest with after-tax money. The amount of loan interest you pay yourself is taxed again when it’s withdrawn sometime down the road when you start taking distributions during retirement.
Technically speaking, this is a form of double taxation. But the economist in us says it would be a mistake to look at this simply in a vacuum. Better to think of it in terms of the available alternatives. If the only available choices you have for short-term borrowing are high interest credit cards, payday loans, or the origination fees and interest on a home equity line of credit are relatively expensive, then the cost of borrowing from a 401(k) plan may still be your best option.
Verdict: Half-True (Misleading)
Finally, when it comes to 401(k) loans make sure you are borrowing for the right reasons. Retirement funds should not be used as emergency funds or savings accounts. While loans can help bridge gaps when access to short-term credit is limited, loans are never a remedy for structural budget imbalances.
Michael Reid, CFA is Managing Director and a Partner at Exchange Capital Management who admits to occasionally robbing himself, but only to the point of needing glasses. The opinions expressed in this article are his own.