Don’t be fooled into thinking that borrowing from your retirement plan is without risks. There are plenty of risks from borrowing from your 401(k) or any other workplace retirement plan. And they can be costly.
A little background
Years ago, plans added loan features to encourage participation. This was way before features like automatic enrollment were common like today. Back then, employees had to choose to enroll and many didn’t. That hurt annual plan testing results. Plans needed a way to get employees to participate. Hello loans. Loans were a way of letting employees know that while they were saving for retirement, they could still get access to their money should the need arise. The idea took off (despite mixed results on increasing enrollments) and most plans offer them today.
Last week’s post detailed how a $20,000 hardship distribution for a 32 year-old could cost $1,000,000 in retirement. The negative impact is felt in two different ways. First, smaller annual distributions… by nearly 20%… to fund your retirement years. Less money each year. Second, a smaller remaining balance to cover unplanned expenses later in life or for leaving for legacy purposes.
Risks of borrowing from your 401(k)
The risk of borrowing from your 401(k) can have similar consequences. “Wait a second”, you say? How can that be? I’m repaying myself, right?. The money is going back into my account. Better yet, you say… I’m paying myself back with interest. How can this be bad?
Well, lots of ways. For much of what follows, I’ll use a similar example as I used in my previous post discussing Hardship Distributions. Quick refresher on some of the assumptions –
- Age 32,
- Beginning Balance $100,000,
- 8% Growth,
- Contributions suspended,
- and for the following comparisons – a $20,000 loan for purchase of primary residence repaid over 10 years.
Sadly, you may not be around to repay
There’s a very good chance you may not actually stay to repay your loan. That’s because tenure at organizations is a fleeting thing. The U.S. Bureau of Labor Statistics in 2018 published the Employee Tenure Summary. According to the report, median tenure for 25-34 year olds was 2.8 years. That’s not very long. In our example, the borrower is 32 years old. The probability of staying at the same company for the 10-year repayment period is pretty slim. And it’s not just the young folks, the report also indicates that for all workers the median tenure was only 4.2 years.
You could argue that you’ll repay the loan if you quit or get fired. Statistically that doesn’t actually happen. In Borrowing From The Future: 401(k) Plan Loans and Loan Defaults published by the National Bureau of Economic Research in 2015, 86% of terminated employees failed to repay their outstanding loans. Only 14% – 14 out of every 100 terminated employees repaid themselves!
When you couple the two statistics – high turnover and high default rates, there’s a pretty good probability you’ll default on the loan. And the consequences are severe. In fact, with any outstanding loan amount, it’s exactly the same as if you had requested a Hardship Distribution. As demonstrated last week, even a $20,000 distribution early in one’s career can have long-term consequences. As much as $372,711 less in spendable income while retired and $736,874 less in the account to pass along to heirs. That’s a considerable cost to borrow from yourself for convenience.
Taxes due when you don’t have the money
Additionally, now you will also face ordinary income taxes and a 10% early distribution penalty tax on the outstanding loan balance. Even if you repaid the loan for a couple of years before leaving, maybe get the balance down to +/- $15,000, it can be a lot of taxes. Assuming 25% state and federal and another 10% for the penalty, that’s an extra tax obligation of $5,250! Remember, that loan money is tied up in the house. You probably don’t have an extra $5k sitting around for Uncle Sam.
Don’t forget about opportunity cost
Ok, so you’re going to beat the odds and stay at the same company for the duration of the loan. That doesn’t mean the risk of borrowing from your 401(k) has been eliminated. One cost associated with borrowing is opportunity cost. Opportunity cost is the what your money could be doing if you didn’t borrow it from the plan. While you repay yourself with interest (typically the prime rate or prime +1) you’re not fully invested in the market. Your opportunity cost is the spread or difference between the market return and your interest rate. That opportunity cost has some long-lasting effects.
The tables below compare the 60-year life cycle of two accounts. In Table A “Ed” doesn’t borrow and in Table B “Bob” takes a $20,000 loan for the purchase of his house at the end of the year. The loan has an interest rate of 4.75% and a 10-year repayment period (I squeezed or rather hid some of the rows to save some space).
You can see the $20,000 account variance immediately. From age 33 to 43 the account variance becomes smaller each year as Bob repays his loan. Yet it never gets to zero. In fact, after the loan is repaid, the variance becomes larger each year. That’s because while Bob was repaying himself 4.75% each year, the market was earning 8.0%. He missed out on 3.25%. Those extra dollars in the account continue to compound for another 50 years. At age 92 (sadly, when both Ed and Bob pass away), the account variance is over $121,000.
This seemingly small variance also impacts Bob’s annual withdrawals when he retires. [Same as the last models – 4% initial withdrawal increased annually by 3% for inflation.] Over the course of his retirement, Bob receives $58k less in income.
You might argue what’s the big deal? It’s about a $180,000 issue over a 30-year retirement. And you might be right. However, I’d rather have than not have that $180,000 to spend or leave my heirs.
One loan typically leads to another
In my experience, one loan usually leads to a second loan (and sometimes to more) if permitted. Folks get caught up in the ease and convenience of just applying for a General Purpose loan and having the money quickly. At that point there’s absolutely no thought given to the consequences. Over time, multiple loans dampen the potential compounding growth of your retirement account by hundreds of thousands of dollars.
Bigger risk if you can’t afford to save
I think there’s another risk in borrowing from your 401(k) that’s even more damaging. That’s the very real risk of suspending your contributions while repaying the loan. This happens all the time. Folks borrow from their 401(k) and then decide they don’t have enough money in their paycheck to contribute to the 401(k). It’s a much bigger risk if you decide you can’t afford to save any longer. Below the tables show the impact over time.
Bob takes the loan and dutifully repays $2,514 each year to retire the debt. But he doesn’t have extra money available. As a result, he shuts down his 401(k) deduction while he repays his loan. Ed on the other hand isn’t tempted by a loan and actually contributed to his account by adding $2,514 each year. The results are shocking! Note: the impact is even worse if you’re missing out on a matching contribution.
Ed’s ending account balance is more than $777,000 higher! He was also able to receive $372,000 more in cumulative withdrawals than Bob over his retirement.
The results are similar to a $20,000 hardship distribution. Because Bob suspended his contributions while he repaid his loan, his account suffered over a $1,000,000 cumulative hit.
Another tax issue too
Others may also point out that there’s another tax issue associated with taking out a loan. You end up paying taxes on the loan repayments twice. You repay your loan with after-tax dollars from your paycheck. When you eventually withdraw those dollars in retirement, you pay taxes again. I’m not a fan of paying more tax than I need to. I’m certainly not a fan of paying it twice.
Think long and hard
So there you have it. Some serious consequences to taking a loan from your 401(k). It sounds easy because it is easy. But that’s not the reason to borrow from your future. Your financial future may be at stake.
Borrowing can be a really bad idea if you quit (or get fired) and don’t pay the loan off. If you stop making contributions to your account while the loan is outstanding; the impact is significant. Borrowing has a detrimental affect on your income during retirement and remaining balance even if you do pay it off. And, you end up paying taxes twice on your loan repayments.
Think long and hard before borrowing from your retirement account. Let us know in the comments below if you’ve been tempted to take a loan from your workplace retirement plan. Did you pay it off? Share your experience and insight.
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