Borrow from your 401k.

A few days ago I was at a dinner party with some friends. We were talking about a ton of different issues from politics to economics and during the course of the conversation privatization of retirement plans came up. One of the folks in the conversation said that he supported privatization because it allowed him to borrow from his own money rather than having it be hidden away. He relayed a story about how he borrowed from his 401k to purchase a car, then was laid off and used his severance package to pay back the 401k loan.

Please don’t do this.

There are a bunch of reasons why this is a really bad idea. I’ll try to debunk the most popular argument that I hear: If I borrow the money, I’ll have to pay interest anyway, so paying myself is the best way to do it!

Wrong. Paying yourself the interest after borrowing from your 401k money is a horribly expensive way to do borrow money. It isn’t the interest payment that gets you, it is the tax payments that get you! When you put your money into the 401k it goes in pre-tax, when you pay it back, you pay post-tax.

Example: If you were to borrow $40,000 from your 401k plan to buy a shiny new luxury car, and you happened to be in a 28% tax bracket paying 5% state taxes as well you’d need to earn $59,701.49 just to pay back your $40,000 principal. Then, when you take that $40,000 back out again, it gets taxed - again!

Let’s run down the example a little further to show why this gets you in the long run. Assuming you can pay back your $40,000 loan in 5 years here is the scenario (assuming the 28% and 5% tax brackets).

Borrow from the 401k

• Loan of $40,000 from 401k, interest rate of 8%, term 60 months
• Interest paid back to 401k - $8,663.35
• Interest earned on money paid back to 401k (Assume 10%) - $10,774.12
• Income required to pay back 401k loan - $72,631.86
• Cost of 401k loan in taxes to repay it ($24,968.51)
• Taxes paid on withdrawal of $59,437.47 from 401k - ($19,614.36)
• Total taxes paid on 401k dollars - ($43,582.88)

Don’t borrow from the 401k

• 401k Balance - $40,000
• 401k Interest Earned (Assume 10% Annual Growth) - $24,240.40
  • Ah… the magic of compounding interest. You don’t get that full benefit when you pay interest to yourself.
• 401k Balance at end of 5 years - $64,420.40
• Taxes on withdrawal of $64,420.40 - ($21,258.73)
• Total taxes paid on 401k dollars - ($21,258.73)

Well, look at that… Not only do you earn more money on the 401k if you don’t borrow from it, but you pay a LOT less is taxes when you get your money back out. These costs, and losses, get a lot larger the younger you are.  Again, compounding interest is there to help, or hurt you. There are two major things working against you when you borrow money from the 401k.

1. Double taxation - this is a killer. You’re 401k money goes into the account pre-tax from your paycheck. When you pay back a 401k loan, this is post-tax dollars.
2. Lower principal balance for compounding gains. If you pull your money out of the 401k, you don’t earn compounding interest on the principal. You pay interest each year on it, but the amount gets lower and lower as you go along.

I’ve assumed a 10% annual gain in your 401k account for this exercise*. You can run it a lot of different ways an get different results. Net/net, borrowing money from your 401k is not a great idea.

Beyond the fact that you are strapping yourself with money payments, you are also killing your tax benefits. If you truly have $811.06 each month to pay for the loan, why not throw that cash into a savings account and save up to buy the luxury car in just a few years. In fact, if you can earn 3% on that money (not to difficult to do), you can pay your taxes on the interest gain and have your $40,000 in cash in only 48 months.

If you were to simply wait 4 years to buy the care and pay yourself first, you’d be able to save a truck load of money on your purchase, and pay cash. On top of that, if you continue to pay yourself the $811.06 a month the 401k loan would have required for the last 12 months, you would end up with a $40,000 luxury car and $10,650.72 cash in your pocket - after taxes - and $64,420.40 in your 401k (assuming no additional contributions). Not to shabby.

There is another nasty side effect of borrowing from your 401k. If you happen to lose your job, you have to pay back the principal amount right away (typically within 60 days) or it is considered a distribution from the 401k. If you’re not at retirement age yet, that distribution comes with a 10% fee.

*The average return in the S&P 500 over the period from 1987 to 2007 was 10.1% - without dividends.

Categories: Personal Finance