Paul Ferraresi

The credit crunch has closed off many loan avenues, forcing debt-burdened Americans to look elsewhere. An easy alternative, but filled with caveats, are 401k loans. These loans are not the best route for most people.

Federal law does not place restrictions on how you can use the money from a 401k loan. On the other hand plan administrators can limit the money to certain purposes. The more common uses are medical expenses and student loans. Loans typically must be paid back within five years.

No matter the reason for the 401k loan, even though you pay it back, it slows your ability to build a substantial nest egg.

Advantages of this type of loan:

• The loan application is much quicker.
• The loan interest rate is usually low.
• There will not be any surprises.
• You can usually borrow up to 50% of the account value.
• With a 5 year payback this forces you to start saving again sooner.
• Some administrators allow for long term loans of 15 years when the funds are used as a home down payment.
• Loan repayments can be done by payroll deduction.

The disadvantages of a 401k loan:

• If you lose your job you will face a major financial crunch. Typically, the whole loan must be paid in full within 30 days of your dismissal. If it is not paid in full, the loan will be deemed an early withdrawal subject to tax and a 10% penalty tax. Hmmm! You have lost your job, no income coming in, and you have to pay the remaining loan back. If the loan is not paid back, you will need to come up with probably 45% of the amount due in taxes. This is the major reason why I do not like these loans.
• You are looking at, in effect, double taxation. The loan is paid back with after tax dollars (unlike your contributions which are paid pretax). When you retire and withdraw the loans funds you pay tax again.
• If you use the 401k loan to buy or improve your home the interest is not deductible.
• You may have to pay a one time fee to the administrator for loan origination.
• If after borrowing you stop making contributions to the 401K, it is a double loss. First, you are not making contributions, and second you lose any match on those contributions not being made.

I often hear people who take out 401k loans use this excuse … “Well, I am paying myself back”. Really … look at this simple example.

Facts of the case:

You borrow $20,000 @ 6% for 5 years. The repayment is about $400/month. The loan repayment of $400/month is a drain on your cash flow so you stop making contributions to your 401K. You have taken a loan of 50% of your balance. The company matches you 50% on your contribution. Assume your money has been invested in an S+P 500 index fund. The S+P 500 has averaged a 13% return since 1926 (dividends included).

Option A: Do not take the loan

• $40,000 balance @ 13% for 5 years = $73,700
• $400 contribution per month @ 13%, 5 years = $33,550
• Tax savings on contribution (33% bracket)
$132/mo @ 13%, 5 years = $11,100
• 50% company match; $200/mo, @ 13%, 5 years = $16,800
• Total value in 5 years = $135,150

Option B: Take 401k loan of $20,000

• $20,000 remaining balance in plan @ 13%, 5 years = $26,800
• Repayment of $400/mo (loan repayment)
Invested @ 13%, 5 years $33,550
• Extra tax cost since loan repayment not pretax
@ 13% opportunity cost
$132/mo @ 13%, 5 years ($11,100)
• Value in 5 years $59,250

Taking the loan produces a loss to your nest egg by cutting it more than in half.

You know a home equity loan that is tax deductible may be a better alternative.

Taking a break from our standard financial education on personal wealth building, I hope you get a good laugh. It is a joke that a friend sent to me and is not intended to offend anyone. This could happen to anyone.

Calling in sick to work makes me uncomfortable. No matter how legitimate my excuse, I always get the feeling that my boss thinks I’m lying. Read the rest of this entry »