EXECUTIVE SUMMARY
401k loans are a feature that some 401k’s offer and may be an option you have in your financial toolbox. But is it the right choice?
The answer: It depends.
Your 401k is designed and works best as a tax efficient way of investing for your future retirement. Using the 401k loan feature as your own personal piggy bank is ill-advised.
But in some cases, considering a 401k loan may actually make financial sense and safeguard your retirement portfolio.
Keep reading as we discuss 401k loans.
A Primer On Debt
Before going in depth on 401(k) loans and the case when it may be appropriate, it’s important to discuss debt in general. Despite what some will argue, having debt is not conducive to wealth building. The reason lies not in the numbers but in the behavior people exhibit when they go into debt. Studies have shown you spend more when using credit (debt).
When the majority of your monthly income is spent paying minimum payments on your home, car, credit card, store card, etc., you lose your ability to save and invest. The wealthy realize this fact: Your income is your greatest wealth building tool. Having free cash flow to invest allows you to take advantage of the amazing power of compounding.
Even the Bible talks about debt in a negative light, saying, “the borrower is slave to the lender.” Proverbs 22:7.
So if you’re here reading whether it’s okay for you to take a 401(k) loan to purchase a new toy, I suggest you find a different article. I want to help you make smart financial decisions, not further a debt addiction.
Reasons to (Not) Take a 401(k) Loan
If you do a quick search, you’ll find people offering many different reasons to take a loan from your 401(k). These vary from:
- Short-term liquidity (cash) needs
- Speed & convenience
- Flexibility of repayment
- Low cost
- Your job is “secure”
- For a “smart” investment
I want to contend with you these are actually reasons NOT to take out a 401(k) loan! The last thing you want to do is turn your 401(k) into just another credit card that makes it easier for you to spend more money you don’t have.
The reality is that a fully funded emergency fund (3 to 6 months of your living expenses) is a much better alternative for short-term cash needs. It’s easier, more flexible and costs less. Not to mention, having an emergency fund can help keep you from getting into further financial trouble when unexpected events occur.
If you don’t have an emergency fund and have a lot of non-mortgage debt, contact me! I will help point you in the right direction on how to get rid of the debt for good.
No Emergency Fund Yet? Emergencies to Consider a 401(k) Loan
Hopefully at this point I’ve impressed upon you the desire to get out of consumer debt and build an emergency fund so you can avoid the temptation to raid your 401(k). That being said, if you are just figuring this out and in dire circumstances, there are certain situations where it may be appropriate to consider a 401(k) loan.
High Interest Rate (double digit) Credit Card Debt
There are a few things to do before you take out a 401(k) loan to pay off high interest rate credit card debt. First, CUT THEM UP! The wealthy do not become wealthy using credit cards and neither will you. Cutting up your cards for good virtually eliminates your ability to get further into debt. Also, try to negotiate a lower interest rate before taking out the loan. Once the balance is paid, continue taking the normal payment amounts and deposit them into a savings to build up your emergency fund. Vow to never go back into credit card debt again!
You Owe the IRS
If you owe back taxes to the IRS, penalties and interest can add up over time. Once you’ve paid off your back taxes, confirm with your employer that your withholding is correct or consider paying quarterly tax estimates to avoid getting back into this situation.
You Are Facing Eminent Bankruptcy or Eviction
If your situation is this bad it’s likely because you have been making poor decisions with your money. (Understatement of the century?) You need to address these underlying issues and make sure that if you take a 401(k) loan that you do not just fall back into this same pit of misery.
If the above situations apply to you then you are in a serious situation. It’s time to get a plan in place to take care of these debts forever and get on the path to financial security. You deserve it!
Advanced Planning Strategies (Mortgage Payoff)
For this advanced planning strategy, let’s assume you are in a stable financial position, meaning:
- You have no consumer (credit card, auto, etc) debt
- Your emergency fund (3 to 6 months of living expenses) is fully funded, and
- You are contributing 15%+ to your retirement
At this point, you are faced with the decision to pay off your mortgage quickly or continue making payments and investing the cash elsewhere.
For example, let’s say you are 57 years old with $50,000 remaining on your mortgage. You plan on remaining with your current employer until age 62. Depending on your personal risk profile, it may be beneficial for you to pay off your mortgage using a 401(k) loan.
When you take a loan 401(k), you lose the opportunity to gain the investment earnings that your funds could earn. For this reason, the benefit of taking a loan goes down to the degree it takes away from the equity portion of your portfolio. When you get older however, many investors become more conservative and move a greater portion of their money to fixed income investments.
In the current interest rate environment, the outlook for fixed income investments is quite challenged. This is because when interest rates rise, the value of fixed income investments fall. When you take out a 401(k) loan, you are required to pay a rate of interest back into your account. In effect, this becomes the fixed income allocation of your portfolio.
Let’s say your mortgage interest rate is 4% and the interest rate on your 401(k) loan is 5%. By taking out the loan, you are now saving 4% in interest by not paying the bank. Furthermore, you are forced to pay yourself 5% on the 401(k) loan. This sort of forced saving may help you save money on interest and also help guard the fixed income allocation of your 401(k) from interest rate risk.
How a Loan Works
When you take a loan, you actually borrow money from your retirement account, with the promise to repay it. According to the specific plan terms your repay the principal amount you borrowed, plus interest, using after-tax dollars. Principal and interest are repaid back into your retirement plan account. If you don’t repay your loan on schedule, your loan may be treated as a withdrawal and be subject to income taxes and early withdrawal penalties.
How Much You Can Borrow
The amount you are allowed to borrow is determined by current regulations and the plan’s provisions. The maximum you can borrow is the lesser of 50% of your vested balance, or $50,000 (minus your highest outstanding loan balance during the previous 12 months). Outstanding and previously defaulted loans with an outstanding balance will impact your available amount.
Have Questions? Need an expert opinion?
If you have more questions I’m happy to help you! We make getting answers super easy, without having to talk to some high-pressure sales person. Just use the secure contact form to ask a question, or email me directly at [email protected], and I’ll get back to you via email within 48 hours to help point you in the right direction. I also offer a free wealth discovery meeting where we can discuss your personal situation and make sure you’re on the right path. Remember, it’s free to contact us and we are fiduciary advisors putting your personal needs first and foremost.
Best of Success,
John Weninger, CFP®
Wealth Advisor
Endowment Wealth Management, Inc.
