Should I Take out a 401(k) Loan?
401(k) loans are generally discouraged by "financial advisors", a term I am using to refer to anybody that hears you say 'I think I'm going to take out a loan from my retirement'. That includes your crotchety grandfather. I requested a 401(k) loan at my previous place of employment and the HR sultan three states away wrote me an email explaining what the terms and conditions of such a loan were ... and also why I should not do it. I furled my brow and grimaced, 'who is he to tell me what I should and should not do?' It was my money after all (ignoring the 1:1 matching vestment from my company on the first 2% but, really, who's counting that? Am I right?) I wasn't totally sure why this gentleman was so adamant that I not take out the loan. So, I did the one thing that I try my best to avoid - I researched the topic and tried to gain clarity. Ew.
Brief Details on 401(k) Loans
401(k) loans are beautiful because it is the only loan where you don't owe anybody interest but yourself. You are essentially borrowing money from your time-traveling past self and paying it back to your time-traveling future self with a little extra cash to thank your past, present, and future self for being a wise investor and a great friend. You can see why I am not a financial consultant. I only understand money in terms of science-fiction, 12-Monkeys references.
Re-wording that: you are borrowing from your own 401(k) plan (which, if you have put in the time at your company, is likely to all be your money or vested company money). Then you are paying back that money into your plan with interest but the interest is to you, not the retirement company or anybody else. In the end, you are financing yourself. The terms and conditions are different for every plan and company but generally speaking;
- you have a maximum allowed loan amount;
- you can only pay back one loan at a time; and
- there is a set time frame to pay it back with the loan payment being automatically deducted from your paycheck.
The number one argument against 401(k) loans is the potential market gains that you would be missing out on for the loan amount. This does make the safe assumption that the stock market - and your stocks, specifically - will continue to increase in value over the life of the loan. However, I started my 401(k) around the end of 2006 and within a year and a half, during the stock market semi-collapse, saw my market 'gains' go the opposite direction of positive (hint: negative). At that point, I would have actually been safer taking out some cash as a loan, although the maximum loan amount for me at the time was probably like $300 and a coupon for Arby's curly fries. I would have taken it in a heartbeat.
But again, assuming that you do not begin investing in conjunction with the worst financial crisis of the last 80 years, you are likely to gain some cash in the stock market. With the loan amount removed from your investment account, you are missing out on said gains.
However, you are only missing out on substantial gains if you are taking out a substantial loan.
How Much is the Loan Amount?
It's a new section so let's reiterate: the only real reason your retirement would be impacted by taking out a loan is if the loan itself was some substantial amount. Even then, most every plan I've ever seen has a maximum cap, limiting the damage that you can inflict on yourself. My issue is that when I want to take out a loan for 2,000 dollars, then the repercussions are nowhere the same as if I were to take out 40,000 dollars (a number I could only dream of having in my retirement as of this writing.) If 'missed' market gains are the only drawback to taking out a loan, then what am I really missing by taking out a $2,000 loan? In the fifteen years that I have had the pleasure of to have a 401(k), I have never bore witness to an annual stock increase of more than 12% ... maybe the generic plans that retirement companies offers me have just been historically ill-managed. In either case, that is $240 on a $2000 loan that you miss out on. Not necessarily nothing but nothing more than a single car payment at retirement time. Plus, as you pay back the loan over the course of the year, you wouldn't be missing out on all of that $240, anyway.
However, 12% of $40,000 is $4,800 ... not chump change at all. So again, what kind of loan are we talking about? A loan to build a rocket ship or a loan to put new tires on your car? There is a considerable difference.
The second drawback is that the loan is paid back in a relatively narrow time-frame comparative to other loans. A $30,000 car can be financed at 72 months for about over $450 a month (assuming no real down payment). A 401(k) for the same amount/APR would be spread over something three years or less which would be almost $900 a month - double that of the other loan. I don't know about you but if I'm paying $900 a month on a car, it better have double-digit cylinders and get me pulled over by state troopers just for being the wrong color.
Again, it all comes down to the loan amount. If you are only taking out one or two grand, then the amount removed from your check is going to be one hundred bucks or less per month. Maybe that is a deal breaker but remember, if you needed to take out the loan anyway, at least this interest money is going back to you and not some bank branch manager.
Pre-Tax / Post-Tax
I can ignore the other draw backs mentioned but I think the only negative to 401(k) loans that actually makes me stop and think about it is the fact 401(k) loans are paid back post-tax. Simply put, Uncle Sam takes out some percentage of your wages for bombing third world countries and funding lobbyists, and from what is left-over, you pay back your loan. In this way, a 401(k) is no different from any other loan because you pay those back with post-tax earnings, as well. In the long run, you are basically just handing the Federal government anywhere from a couple hundred to a few thousand dollars from your retirement but really in most cases, this is not so much 'double taxation' but a tax shift. For example, if you are using the loan to purchase something, that loan money is not taxed as income at the time of dispersement (which equates to what we will call the 'loan repayment tax'). It gets to be a bit convoluted and I just rely on the general wisdom that the government is going to tax me and screw me over one way or the other so I might as well do what helps me get by at the time. Financial consultant pro tip 101 ... for FREE, no less!
Any Other Drawbacks?
Apparently some individuals decide the best course of action is to take out a 401(k) loan and to offset the cost of paying back that loan, they suspend contributions to their retirement. In this scenario, they are losing out on market gains from their loan amount, missing out on market gains from their own contributions, missing out on their company match, and additionally whatever market gains come from that company match. This seems less of a knock against 401(k) loans and more of a choice by whomever is taking out the loan. We all have different financial situations that erupt in our lives and maybe a retirement hit that effects our geriatric selves is worth it in the now. All I can say is that if money is so tight that you are offsetting loans by removing 401(k) contributions, it doesn't matter who you are borrowing money from - you're in a rut and need to get out of it in a timely manner with as little damage as possible.
I think a lot of financial advice columns, articles, etc. online only talk about big retirement accounts and big numbers, forgetting that most of us don't have that sort of cash. According to Fidelity, the average retirement account at the end of 2014 was approximately $91,000. That's not very high, considering it is supposed to provide for decades. Also, when they say 'average' we will just assume that 1 out of every 2 people have less than that amount and so, dipping into a 20k retirement account for a 2k loan hardly seems like a big deal when you're just trying to make ends meet. A lot of times people want to just be told what to do and they click on articles such as my own looking for an answer and, like all things in life, there is no general 'black-and-white' response. Your situation is different than mine but I can say this much - I have taken out 401(k) loans three times in my life and I have not regretted it yet (then again, I'm not 65 years old and on the precipice of needing every penny I can get).