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« Ed McMahon's Home Faces Foreclosure | Main | Off Topic: Euro2008 »

June 04, 2008

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I have heard this reasoning many times but I have to admit I have never understood it.

In the context of its better not to borrow the money at all it makes sense but in the sense that if you are going to borrow the money anyway, is it better to borrow it from a bank or from your 401-k I don't see why the 401-k is such a bad option.

You do not disrupt your earnings stream on that money because it has to be paid back with interest which as the article pointed out is usually a couple points above prime.

So you would currently be growing your 401-k earnings by about 7% annually on the money that you borrowed (which by the way makes the stock market returns of this decade look paltry). When the prime was 8% (less than 1 year ago) then you would be growing your returns at 10%.

And you would have paid that money to a bank anyway so now you are putting it back in your 401-k and you are losing the option of making 20% on your money but you are also losing the option of making 0% or losing 10% on your money like has happened many times this decade.

Its a gamble either way but 7-10% guaranteed return versus maybe getting more in the market? That doesn't seem like a big risk. In fact it seems like most financial advisors would probably say if you can get 7-10% risk free versus maybe getting more in the market to take the 7-10%. The long term historical return on the market is no better than that either.

So why again is it so damaging to take this loan?

Some reasons I can think of...

1. When you take a loan from a 401(k), it is immediately due upon leaving a company. This makes it riskier, and somewhat ties you down to the same company even if you come upon a better opportunity elsewhere.

2. The money that went into the loan was pre-tax. However, you can only pay the loan with income that has been taxed, so it's an expensive loan, tax-wise. You'll be taxed on it again when you take it out.

3. Taking a loan to put down as payment on another loan is risky leverage.

4. If you got a higher percentage mortgage, the rate would probably be lower than the 401(k), and likely tax deductible, too.

Julia's 1,3 & 4 points are the reasons I wouldn't do it.

I don't really see what you mean by #2 though. You aren't really "double taxed" on a 401k loan if thats what you mean.

Another big reason IMHO is that generally you are expecting your 401k returns to be around 10%. Thats what we should be aiming for in general over the long run. The % rate you pay yourself on a 401k is generally going to be less so you're losing some of your interest gains. This is based on the general assumption that return on stocks > interest rates which is true long term.

Jim

Julia is right. You do get "double taxed" in the end. Your money enters a 401k pre-tax. A loan against it is paid with "taxed" dollars (once). When you access that money again in the future, you get "taxed" again according to your tax bracket (twice). This is one of the reasons why we pulled the plugs on our 401k and IRA! You lose liquidity, utilization, and control.

1. is true. However its usually not the main arguing point. Usually its argued that you are somehow damaging your retirement earnings which is mostly the argument being made in this case too.

2. is irrelevant. The assumption made by a couple commenters here is that somehow you would have had better tax treatment on this money if you borrowed it elsewhere but this is not true (unless its in your mortgage). You would have paid the money to the bank with after tax money too. For example if you borrowed $1000 at 10% from the bank after 1 year you would pay the bank $1100 and be out your $100 of interest. Meanwhile if your 401-k account had 10K in it and the stock market went up 10% you would have 11K in your 401-k, All 11K would be taxable when you take it out. Now if instead you borrowed $1000 from your 401-k and if interest was 10% then assume you paid it all back at the end of the year (to make the math easy) You would pay $1100 back to your 401-k and would be out the $100 in interest you paid. The original $9000 in your 401-k would now be worth $9900 and when added to the $1100 you paid back your 401-k is now worth 11K. All of it is taxable when you withdraw it. So in both cases. You pay the exact same interest. You are out the exact same amount of money. Your 401-k at the end is worth the exact same amount. And the amount of taxes you will pay on your 401-k when you withdraw it is exactly the same. Both situations are 100% equivalent without a single difference (except that borrowing from your 401-k is way easier than borrowing from a bank and has no fees associated with it).

3. is also irrelevant. If you don't need the loan then you don't need it. If you can find other sources great. But if you need a loan then the question is bank or 401-k. Thats the only way you can compare them. You can't say taking a loan from your 401-k is risky but from a bank is not. They are the same risk as far as leverage goes. So given that risk, is it worse to take the loan from your 401-k than from a bank. I argue no (except for the issue of having to pay it back if you leave the company - however presumably if you would have qualified for a bank loan earlier you can get one now to pay back the 401-k and then you are in the same situation as if you had just borrowed from a bank to begin with).

4. If you can get a morgage loan that is certainly a good option. In today's market, that is probably almost impossible. Also, its not tax deductable when you take a home equity loan unless you put the money back into your home. Once again though, mortgage refinances and home equity loans have fees and costs associated with them. So I think it would take some analysis to see which turned out better.

A comment suggesting the stock marker returns more than interest is a bit sketchy because that statement is made with respect to interest you can receive on your money. but interest paid when borrowing is always higher than you receive. The interest rates I quoted 7-10% which are the range of 401-k interest at 2% above prime that would have been paid in the last few years is right in line with long term stock market returns. And as I had stated, its guaranteed. Stock markets can go through long periods of no returns as we have been in for quite some time now.

So I am still where I was. I do not understand the fire alarms people send off about borrowing from your 401-k. Atleast I don't understand them as they are presented like it somehow is the worst place to borrow the money because you are hurting your retirement. I don't see it. And I can't come up with scenarios that show it either.

The one place I would raise the alarm is that for people who are undisciplined it may be a tempting easy source of money that allows them to spend money unwisely that they should never have spent because they think since its their own money its not the same as borrowing it. When it comes to people being stupid with their money there are all kinds of things that people who are poor financial managers should avoid. Certainly credit cards, no interest no money down purchase agreements etc all fall in that category. So for those people they basically shouldn't be allowed to control any of their own money anyway because they are just flat out financially irresponsible. This group has become a rather large segment of our society unfortunately.

However for those people who are responsible with their money I do not believe there is any great danger in borrowing from your 401-k. I have never done it. But I think its a perfectly reasonable thing to do if the circumstances make sense when you pencil it out.

And with respect to my latest comment about people who are irresponsible and about borrowing from your house. In the past couple years mortgage equity withdrawal was running at rates that were many times higher than ever before. That has been shut down to almost zero.

So these people who were financing their life style out of their home equity have had to find a new way to spend more than they make. And what are they doing? Loans from 401-k's in 2007 are nearly 100% higher than they were in 2006. Thats the kind of 401-k loans that should be avoided. Borrow the money out of your 401-k to keep spending money you don't have. Some people just can't be trusted with their own money.

"Some people just can't be trusted with their own money." - Trusting the government with your money isn't all that better. When you leave money in a 401k, IRA, etc., you have a silent partner, Uncle Sam. Not only does he get a piece of the cake, he gets the first bite.

Paying tax on your money twice is not smart nor can there be any way that will make it acceptable.

"When you leave money in a 401k, IRA, etc., you have a silent partner, Uncle Sam. Not only does he get a piece of the cake, he gets the first bite."

In a 401-k he gets the first bite when you withdraw it but after you have compounded it tax free for years. When you do not put it into a 401-k thats when he really gets the first bite. The first bite before you compound it and the first bite of all your compounding every year. And that makes your final numbers much smaller. Uncle sam is your partner no matter how you do it. He is just a lot more vocal about it if you don't use a 401-k because he sends his goons to your door every year to confiscate a big portion of your money.

I would like information about early retirement withdrawal from levi strauss fidility employee insurance at the main office in San Fransicio. I'm a former employee of the plant in Roswell New Mexico which closed down in the year 1997.

I need information about early withdrawal and what is the amount in my retirement account?

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