Financial Planning Highlight
Making a loan to... yourself.
A survey caught our eye this month, showing an uptrend in loans being taken from 401(k) plans during this recent economic downturn. We share it with you here and take some time to explain the nuances of making a loan to... yourself.
According to this Aon Hewitt survey, the percentage of accounts with loans taken against them increased from 22.3% to 27.6% between 2007 and 2010. Looking into this, our research found that sometimes a 401(k) loan is in fact your best option... and other times it compounds an already bad situation. As always, circumstances matter and it always helps to make an informed decision. We review the rules for taking these loans and the situations when it makes sense, and when it doesn't.
How Much - You can generally borrow 50% of your vested account balance, up to a maximum of $50,000... ok, pretty straight forward. Now, try to comprehend this next part on your first try (we didn't): If you have had an outstanding loan in the previous 12 months, then the amount you can borrow will be reduced by the highest outstanding loan balance during that period minus the outstanding balance on the day of the new loan.
How Long - It must be paid back within five years if you are using the loan for anything other than purchasing your primary home. If the loan is for your primary home you can stretch out the payments over a longer period of time as detailed in the plan documents. *If you get terminated from your job, the loan is payable immediately. Huge bummer, but a point so important we will pick it up again later.
Why These Loans Are Grrrreat!
Convenient - Simple application, usually low or no fees involved, no credit check. Far more convenient than any bank we know of.
Low Interest - Most plans charge prime rate plus a percentage point or two. This is cheaper than most of us can obtain from traditional loan sources.
Interest Paid to You - Because the loan is from an account you own, the interest you pay will go to your account. That is a lot better than paying a bank or credit card company.
Why They'rrrre Not!
Risk of Termination - Under most 401(k) plans, if you are terminated from your job you must pay back the entire balance within 30-60 days or the loan is considered in default (the equivalent of a distribution). What this means: you owe income tax on the loan amount and, if you are younger than 59 1/2, a 10% penalty to boot. Not the kind of news you need on top of a job loss.
Lower Potential Returns - Taking a loan is like buying a low yielding bond (at whatever rating you give yourself!) within your 401(k). If you had that money in ...ahem... better performing holdings you could earn a higher return on your investment.
Lower Long Term Savings - The Aon Hewitt survey mentioned above also notes that 401(k) participants who take a loan tend to lower their retirement income from 7%-25%. This is due to lower returns, lower contributions, and defaults by those who take loans.
Shakespeare said to be neither borrower nor lender, and here you are both! More seriously, a loan from your 401(k) can make sense when used to pay off higher interest debt, or for buying a house when rates are much higher than your 401(k) loan rate. If you are looking to pay for your trip to Vegas or examining credit options that support a lifestyle beyond your means, then... not so much. If you choose to take a loan, your first step is to protect yourself from the its downside. Most important, if there is uncertainty in your employment status, you must have the means to repay the loan if it is called due to termination. Also, the loan repayment should not be seen as a 401(k)contribution. If you do not pay the loan and continue making your regular contribution you will have less money in retirement (note: some plans stipulate you repay entire loan before resuming contributions). If you are worried about the lower return on your account due to the low interest then you can increase your allocation to equity-based assets with the remainder of your 401(k) balance. Remember this, for asset allocation purposes the loan should be viewed as a low yielding bond issued by yourself to your 401(k) account.
**I Am Getting Double Taxed. No, Suze, You are Not**
A common held misconception, most visibly by Suze Orman , is that you are getting double taxed on a 401(k) loan because you have to use after tax dollars to fund a tax deferred account. The idea is that because you have to use your current income to make the loan repayment, you get taxed right now on the income and then you get taxed when you withdraw the money. Fair point, but remember a loan from the bank requires repayment using after tax dollars as well. The real difference is that you are now paying the interest to your 401(k) account rather than the bank. Suze is confusing a loan repayment with a contribution. They are not the same.
As always we welcome your comments or suggestions. Stop in, call 212.949.0494, or simply 'reply' to this email.
Thank-you for reading,
John O'Meara, CFP®
Michael Keating, CFP®