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401k Coach Testimonial 

Jeff Barnes, founder of Barnes Retirement Plan Specialists in Memphis, attended The 401k Program in 2007. "Since then," he says, "we've had average annual growth in our 401(k) business of over 40% and we ended 2010 with quite a few prospective plans in the pipeline." Jeff attended Years 1 and 2 and "is looking forward to the Master's Program." 

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 401(k) Loans: What You Should Tell Your Participants

A 401(k) loan can be tempting in today's difficult economy, especially since many Americans are faced with credit card debt and high interest rates, low savings, and the desire to remodel the kitchen or bathroom, or buy that motorcycle they've always dreamed of. However, before your plan participants tap into their 401(k) for an "easy loan," the pros and hazards of these loans should be thoroughly discussed. Below are some of the key points that you should discuss with your participants before they decide on a 401(k) loan:

Pros

Borrowing from a 401(k) account is extremely easy these days. The Investment Company Institute, the national association of U.S. investment companies, claims that in 2010, 18.2% of participants in 401(k) plans had loans, up from 16.5% in 2009.

• Loan Terms: Participants can borrow 50% of their vested retirement account balance, up to $50,000. 
• Interest: The interest rate is typically a low rate of prime plus 1%. 
• Convenience: Participants pay themselves back via payroll deductions directly into their 401(k) accounts. 
• Term: They have between one to five years to pay off the loan. 
• Additional Cost: Generally, a one time $125 loan fee. 

Most 401(k) providers make it easy for participants to calculate the loan pay off amount and monthly costs by going on line to their website and modeling different scenarios. With the click of a button, a loan check can be in the mail in no time. All of this may sound attractive, especially if your participants are staring at a credit card balance with a 15% interest rate and feeling as though they'll never pay it off. Taking out a loan from a 401(k) at 5% interest and paying it back over 5 years seems to make sense.

But wait, does it really?

Hazards

While the advantages of taking out a loan from a 401(k) may seem beneficial, there are far more hazards and significant short and long term expenses.

• Cost of Default: if the participant dies, become disabled or leaves his or her job, the loan must be repaid in 60 days. Failure to do so means that the balance will be counted as a distribution and he or she will owe taxes (15% or more), plus a 10% penalty on the unpaid amount if younger than 59½. (Read Here for IRS Penalty Exclusions) 
• Failure to Make Payments: If the participant fails to make monthly payments after 90 days, the loan will default and the same taxes and penalties apply. 
• Cost of Loan Repayments: The real cost to repay the loan is not just the interest rate, it's the tax cost as well. When contributing money into the 401(k), participants do so with pre-tax dollars. When they pay back a loan, it is with after-tax dollars. If they are in a 25% tax bracket, every $1 only gives them $0.75 toward repaying their loan, which will be taxed again at retirement when withdrawn. This means that they have been doubled taxed. While the loan interest rate is low, the cost of repayment can be 35-50%, far worse than any credit card interest they may be paying. 
• Significant Reduction in Retirement Savings: This is by far the greatest hazard to taking a loan from a 401(k) and the one most participants fall to understand and calculate. Their 401(k) is what I call the "personal paycheck manufacturing company." Someday, retirement will come and with it, the prospect that the paychecks will stop. Where will participants' paychecks come from to maintain their standard of living to their life expectancy? That could mean they will need an income, or "paycheck for life," for 25 to 30 years. Where will that income come from? If you're thinking social security, think again.
  
  The 401(k) plan and the assets growing inside the plan need to create that paycheck.  When participants take loans from their retirement accounts, they are, basically, robbing themselves of those future retirement paychecks and cheating themselves out of that future lifestyle. Time and money are the two greatest allies in accumulating enough money in a 401(k) to generate that paycheck for life. In addition, when participants take loans, many companies do not allow them to continue to contribute to their 401(k). Oftentimes, participants stop making their contributions because they can't afford to make both their loan payment and the regular plan contribution. This only compounds the negative impact of a loan. 

 Let's look at a hypothetical example:   

• Sally is 35 years old. Her income is $40,000. She has $20,000 in her 401(k). She is contributing 6%, or $2,400 a year, and her employer matches 3%, or $1,200. Assuming she can earn 8% on her 401(k), she would have $583,723 at age 65. She decides to borrow $10,000 from her 401(k), to pay for a new car. She will pay it off in 5 years at 5%. She feels good about this because she is paying herself back the principal and the interest. However, she can no longer make her 6% contribution and pay back the loan each month, so she stops contributing. She not only loses the compounding on her 6% contribution each year, she also forfeits her employer's 3% match (effectively giving up a 50% guaranteed return on her money). Now at age 65, she will only have 456,673 or a loss of $127,000! Assuming she earns 6% on her money in retirement she would loose $7,620 of additional annual income or $630 a month of her paychecks for life! If she lived for 25 years, she has lost a total of $198,120 of income! For retirees, this can be the difference they need in order to pay for their medical expenses or prescriptions.

While taking a loan from a 401(k) may appear easy and inexpensive, in the long run it usually is the most expensive loan a participant can take. It is important that your plan participants exhaust all means to manage their cash needs, such as a bank, family or home equity loan. If you want your participants to have a successful retirement, discuss the benefits, but warn them about the risks. A 401(k) loan violates the "golden rule of finance" - never take money from the paycheck manufacturing company.

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