Wednesday, April 8, 2015

Should You Borrow From Your 401(k)?
Most Americans have little, if any, savings. After hitting a low of 1.5% in 2005, the personal savings rate has rebounded a bit to just under 4%. This is still much lower than the 8% to 10 % it was between 1962 and 1982. These days, most people's savings is in the form of a retirement account, most likely an employer sponsored 401(k). With so little savings outside of retirement accounts, that big chunk of retirement money can be a large temptation for some people. Most 401(k) plans allow the employee to withdraw up to 50% of the total as a loan. This can be a relatively pain-free way to borrow money: there is no qualifying process, so you can't be turned down. The interest you are charged goes back into your own account, so you are paying interest to yourself. It sounds like a great deal, but is this something you should do?

Most financial advisers say no. I agree with them, for reasons I will get into later. But I came across this article on Nerd Wallet a while ago and was quite flabbergasted at it. I generally find the articles on that site to be useful and full of good advice. This article was even written by a professional certified investment advisor and broker. He is not, however, a Certified Financial Planner, which may explain his viewpoint.

In the article, the author argues that now is a good time to borrow from a 401(k). He points out that, for most advisors, the 401(k) is the "third rail" of debt management - meaning that it is a highly controversial topic and most would recommend not touching it. He then spends most of the article explaining why advisors do not recommend borrowing against it. His case in favor of borrowing against a 401(k) is not presented until the last couple of paragraphs and can be summed up as "The stock market is at a 6 year high and therefore, will likely drop soon. Borrow now to avoid the loss."

As he rather quickly glosses over, this is simply another way to say you are timing the market. Timing the market doesn't work. Period. I wrote about this extensively here and there have been countless studies proving the failure of market timing. As a registered broker, i.e., someone whose job it is to buy and sell stocks, it seems to me that the author has a bias towards frequent trading and trying to outsmart the market. As Warren Buffett says, don't ask the barber if you need a haircut.

What really bothered me about this article was the fact that, on a widely-read financial website, he put forth this position and failed to mention any of the possible downsides to borrowing against a 401(k). And, to my mind, there are at least two very signifiicant drawbacks that deserve special scrutiny:

  1. Money you pay back to a 401(k) loan is, in effect, taxed twice.
  2. Any loan you make must be paid back in full shortly after you leave your job - regardless of if you left voluntarily or involuntarily.

Let's look at the first one. The vast majority of people contribute to a 401(k) through payroll deductions made with pre-tax dollars. That money grows in the 401(k) tax-free until you withdraw it at retirement, when it is taxed as regular income. When you take a loan and make payments back to your 401(k), the loan payments are made using after-tax dollars. The Nerd Wallet author sees no problem with this because, as he points out, if you got a loan from any other source, it would also be repaid using after-tax dollars. He goes on to write "...If a person borrows from his or her Roth 401(k), there is no functional difference between the loan interest that is repaid and the participant’s own regular after-tax salary deferral contributions."

Whoa.. wait a minute here! Now we're specifically talking about a Roth 401(k)? The term 401(k) is used 21 times in his article. How many times is Roth 401(k) used? Exactly once. So which 401(k) type do you think most people are going to assume he is talking about? Right. A traditional 401(k).

If we are talking about a Roth 401(k), his statement is correct. However, Roth 401(k)s are still fairly rare, so few people have them and, in any event, his article sure doesn't go out of its way to specify which 401(k) type he is talking about, nor does he mention the fact that there is a difference.

Your average reader is going to assume he is referring to the traditional 401(k). Now, you can make after-tax contributions to a traditional 401(k) plan, however, very few people actually do this. The vast, VAST majority of contributions to a 401(k) are made using pre-tax monies deducted directly from the employee's paycheck. So the author is employing a rather sketchy slight-of-hand here to support his position. 

When you borrow money from your traditional 401(k), what is really happening is you are making your loan payment with after-tax dollars - your take-home pay from your paycheck. That money, which has already been taxed at your current income tax rate, goes back into your 401(k). Then, when you retire and withdraw that money, it's taxed again. Congratulations, you just paid taxes twice on that money. (This won't happen with a Roth 401(k) because distributions from those are tax-free.)

But far more troublesome is the author's lack of mentioning my second point - if you leave your job for any reason, be it voluntary or involuntary, any loans you have against your 401(k) must be repaid, in full, usually within 60 days. Failure to do so will result in the loan being recharacterized as an early distribution and subject to a 10% early distribution penalty tax. This applies to both traditional and Roth 401(k)s. So if you have a 401(k) loan and you are laid off or downsized, not only do you have the financial stress of an unplanned loss of income, you also have the stress of a large loan becoming due right when your income disappears.

To not even mention this in an article on a financial education website is, in my opinion, unconscionable.

I won't say you should never take a loan against your 401(k). I'm sure there are some situations where it is beneficial and perhaps even the best choice to make. However, those cases are rare and a 401(k) loan should be made only after some serious consideration of the ramifications.


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