Why Borrowing From A 401(k) Might Not Be The Best Idea

Last week, I taught a class at the Plymouth campus of Cape Cod Community College with Gerry, another advisor in our Plymouth office. This class has become quite popular. It is specifically designed to help students prepare for a sound retirement by teaching them how to build a solid retirement system. Cutter Family Finance readers have come to learn over the years the importance of having a retirement system that includes an advanced tax plan, an income plan, and an investment plan. In this class, we also delve into techniques that focus on the distribution stage of our financial life cycle. You see, we all have two financial stages in our lives, the accumulation stage (gathering assets) and the distribution stage (disbursing assets). I find that oftentimes folks put more focus on the accumulation stage of their lives without understanding the importance of the distribution stage and without learning about strategies to pull money out of their savings effectively and efficiently.
 
The way in which money is withdrawn from a retirement plan, and overall portfolio, can make a huge difference on a retiree’s tax burden. And, frankly, the combination of the distribution plan and the investment plan will often dictate a portfolio’s sustainability.
 
In class, I began talking about 401(k) withdrawal strategies in retirement that can help stretch that hard-earned money, when a nice guy, let’s call him Paul, raised his hand. Paul’s question circled around the issue of using his 401(k) before he retires, as an emergency fund, since many companies let employees borrow against their 401(k) while they are still working.
 
Hmm . . . I will share with you what I shared with my friend Paul.
 
Folks, borrowing against a 401(k) is one of my least favorite strategies, even for emergency funds, and should be used only as a last resort for a variety of reasons.
 
First of all, if you borrow from your 401(k), that loan must be repaid, with interest. Those interest payments are made with after-tax dollars from your salary. So, think about this for a moment. Years down the road, when you take your withdrawals from your 401(k), just about all of it will be taxable at your ordinary tax burden rate. Generally speaking, you will have to pay tax on those after-tax interest payments, which means you are paying taxes on those dollars twice.
 
Not a very tax-efficient distribution plan.
 
Folks often choose to borrow from their 401(k), rather than other sources, because the interest rates on a 401(k) loan are usually lower than other forms of debt. I get it. But it is important to consider the effect of the double taxation explained above. Who wants to pay Uncle Sam twice? And, as I have written over and over again, he is not even your real uncle!
 
You also need to think about the growth of your 401(k) and the damage you are doing to that growth if you borrow against it. While you will be paying yourself back with interest, let’s say 3.5 percent, if left in the 401(k) and invested in equities (oftentimes an appropriate allocation for someone still in their working years), that money could likely earn significantly more than that. Historically, equities have given us an average annual rate of about 7 percent. So, by borrowing against your 401(k), under those circumstances, you would be losing a potential of 3.5 percent growth on the money borrowed, while you pay yourself back.
 
Not a very sound investment plan.
 
Now let’s talk about default risk, which is the risk that you might not pay the loan back. When you take a loan against a 401(k), the employer usually deducts payments over a series of months or years until the loan is paid off. Simple, right? No risk of default, since the payment automatically comes out of your check. Well, not exactly.
 
What happens if you change jobs and the loan is not repaid? Here is where it gets a bit complicated. Generally speaking, when a participant in an employer-sponsored plan changes jobs, that participant will usually have two to three months to repay a loan. If the loan is not repaid in the defined time frame, the loan will be deemed in default and the balance still due will be considered income and therefore subject to ordinary income tax. And if that participant happens to be under the age of 59 1⁄2, a 10 percent penalty to Uncle Sam will be due as well. There is that pesky uncle again. This scenario would also impact the accumulation of that tax-deferred retirement account, which will impact income down the road.
 
Not a very good income plan.
 
Then there is the risk of a reduced contribution rate. Oftentimes, when a participant takes a loan from a 401(k), there is a money crunch, so he or she will likely struggle to repay that loan with interest. What we find is that folks will choose to cut their contributions, in order to afford that repayment. Therefore, they are not building their retirement savings as aggressively as they otherwise would be and should be doing.
 
Folks, I’ve spoken in the past about the importance of maintaining an emergency fund. Having one allows you to take on unexpected expenses without having to disrupt your retirement system. Look, I get it. If it is between losing your home or tapping into your 401(k), well, that answer is easy. But under most circumstances, your 401(k) should not be viewed as your emergency fund. The devil of any financial situation is in the details, and the details of a 401(k) loan rarely work in your favor.
 
Be vigilant and stay alert, because you deserve more.