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June 25, 2008

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Something is wrong here...
By assuming contribution stops, it means whether he borrows from 401k or from somewhere else... his contributions would still stop... Either way.. he still loses 145k from not getting match and compounded interest... has nothing to do with borrowing from 401k or not.

They should do the calculations again WITHOUT changing existing contributions... that way we separate the cons of borrow from 401k by itself, rather than throwing a different factor in the mix (such as stopping contributions in its entirety.

Yeah I agree with Dangger, what they are really doing is just mostly showing the impact of stopping your 401k contributions. It should be clear that stopping your 401k contributions reduces your retirement earnings. But that says nothing really about the actual merits of a 401k loan versus a loan from another source.

If you compare a 401k loan and reduced 401k contributions to a loan from another source and continued 401k contribution then thats really an apples to oranges comparison.

TO really see the DIRECT impact of borrowing from a 401k you should keep everything else equal. While keeping all else equal compare 1) taking a $50k loan from the 401k versus 2) taking a $50k loan from a 3rd party.

I would suspect people stop their 401k contributions during their loan because they are in financial jeopardy and cant afford to contribute to the 401k. OR they may be simply ignorant of how the loan from the 401k works versus normal 401k contributions and maybe they think the loan repayments adequately replace their normal 401k contributions.

Jim

Actually, many (most?) 401k loans stipulate that no contributions can be made while there is an outstanding loan against the account. In that case, one must take that stoppage into account.

I'd never heard of that. It certainly has not been true for the companies I've worked at. Contributions and matching continue while the loan is being repaid.


"I'd never heard of that. It certainly has not been true for the companies I've worked at. Contributions and matching continue while the loan is being repaid."

You are correct Linda. I've never heard of that either.

While I agree that taking loans from a 401k is almost always a bad idea, there may be a time where your emergency fund gets depleted by a medical bill or for a down payment on a house. If you can get by with a much smaller paycheck for six months, you can take out a small 401k loan ($3000 or so) for that period and not lose much sleep over the potential loss on your returns.


I was just asked yesterday by a friend if I thought it was a good idea to borrow $30k on their 401k to invest in a business that "would get way better returns."

I had them take a step back and look at why they didn't have $30k on hand when they've been making well over 100k per year for several years now. It's not that the business is a bad idea, it's that their money management, up to this point, does not instill confidence that the business money made will go toward paying off the loan.

I would aggressively raise cash before I would borrow against retirement - sell things, pick up some side jobs, etc.

you also have to pay takes on that money twice. You pay back the loan with after tax money and then you are taxed again when you take it out.

I think there are a couple of things to consider:

1. Are you going to take out a loan?
A. If you NEED to buy something and CAN'T pay for it without the loan, one option would be a 401k loan.
B. If you don't NEED something or can pay for what you NEED without the loan, DON'T TAKE A LOAN!

2. Are you going to stay with your current employer for as long as the loan is outstanding?
A. If not, your loan will come due soon after you quit/leave/terminate.
B. If you plan to be(and your employer plans to keep you!) in the same position for the life of the loan, it may be an option.

3. Can and will you be able to make your regular contribution?
A. If not, you might reconsider if what you are financing is a NEED!
B. If yes, this may be an option.

4. What are the loan provisions? What are the fees to take the loan? What is the interest rate? What is the spread?
A. Most plans will charge a fee of $50-100 up front for paperwork associated with a loan.
B. Most plans will make you pay interest, of which you will keep most. They may charge a one-half to 1 percent spread. IE - you pay 7 percent, but only get credited for 6% in your account. The plan keeps the difference for admin fees, etc.

5. Why would a 401k loan be a bad idea?
A. Are you taking the loan to pay an ongoing debt? student loans, mortgage etc? This option is preferable to foreclosure if you have a short-term cash flow problem, but if probably an indicator of poor spending habits.
B. Are you quitting/retiring/getting fired soon? Your loan will come due 60 days after termination and it WILL be hard to get an outside loan without being employed or having a spouse that is employed.

6. When could it be a good idea?
A. Uncertain stock market! - As long as you pay each month, you have a guaranteed (positive!) return. If you can't stomach the roller coaster of late, and don't want to take out an outside loan, this may be an option.
B. Better returns elsewhere. If you have the opportunity to invest in a business that will return more than 15 percent, this might be a good option.

7. Why is everyone telling me this is a bad idea?
A. Your plan administrator may be paid a percentage of the dollar amount in the plan, this may give him or her a financial incentive to discourage these types of loans.
B. They don't understand... ie-"You have to pay taxes on the money twice" or "the loan is paid back with after-tax dollars"
Yes, you are paying taxes twice, but it is actually BETTER to take a loan from yourself than the bank using the same rationale. $10K loan at 6% over 3 years from a bank, you will pay almost $2000 in interest. If you take this from your policy you will pay $2000 in interest to your policy, which will continue to grow TAX-DEFERRED. You won't pay tax on your gain from the interest until you start taking distributions. Note: this is not efficient if you are earning significantly more than 6% in the account.

Yes, it is an after-tax dollar, but it is the same as an after-tax dollar that you would use to pay back ANY LOAN!

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