A Debate on 401(k) Loans

August 04, 2016

Asking questions and challenging assumptions are important components of financial self-defense. That’s why I was glad to see one reader take the time to raise some interesting points contesting some of what I wrote a couple of weeks ago in a blog post called “The Hidden Downsides of a 401(k) Loan.” Since other readers may have similar concerns, I thought it would be useful to address them. Besides, I love a good, friendly debate! Here are the 401(k) loan downsides from the original post, the reader’s critiques, and my responses:

Downside #1: You lose out on any earnings:

Critique: “You are wrong because the 401(k) loan continues to be a plan asset – bearing a fixed rate of interest. Instead, you should have encouraged her to reallocate so as to maintain her asset allocation (equity position) – treating the 401(k) loan principal as the fixed income investment it is.”    

My Response: Yes, it’s true that the 401(k) loan continues to earn a fixed interest rate, but that’s interest you’re paying yourself. If you take money out of your savings account and then pay it back with “interest,” I wouldn’t call that earnings. Reallocating the remainder of your 401(k) balance is an interesting idea though that could help make up for the lower earnings.

Downside #2: Your payments may be higher.

Critique: “Are you seriously suggesting that a cash advance using a credit card (with interest rates of 15% – 30% or more) is a better liquidity solution because the minimum monthly payment might be less if you stretch repayment out over 20 – 30 years instead of 5 years?  That is so obviously bad financial advice I don’t know what to say.”     

My Response: I certainly wouldn’t say that a credit card cash advance is generally better than a 401(k) loan. I’m simply pointing out that using a 401(k) loan to pay off high-interest credit card debt could actually increase your cash flow problems because the payments on the 401(k) loan may be higher than the credit card debt.

Downside #3: You also can’t eliminate a 401(k) loan through bankruptcy.

Critique: “Are you are suggesting that when entering into a debt obligation, one consideration should be that if the combination of mortgage, car and 401(k) debt become unsustainable, you should anticipate being able to stiff the creditors? Remember that a plan loan is secured debt, secured with your vested assets. So, you can default on a 401(k) loan anytime you want (just stop repayment) – you don’t even have to declare bankruptcy.  However, I am not sure why you would want to stiff yourself.

My Response: I’m suggesting that if you’re considering filing for bankruptcy protection, you may not want to use a 401(k) loan to pay off debt that would otherwise be discharged in the bankruptcy. (As for “stiffing creditors,” keep in mind that creditors assume the risk that you may employ this legal protection and charge higher interest rates accordingly.) It’s also hard to default on a 401(k) loan when the payments are withheld from your paycheck.

Downside #4: You may not be able to take another loan.

Critique: “Really. If the plan only provides for a single loan, your recommendation is to borrow all you can and put the amount you did not need at this time into a passbook savings account or a money market fund? That is almost as bad as your recommendation concerning credit card debt. However, I will agree with you that this is one likely result where, based on “expert” advice, plan sponsors amend their plans to limit access to a single loan.”  

My Response: If you’re going to take your only allowable loan and have no other emergency funds, you might want to borrow more than you need and put the remainder in savings. This can help you avoid accruing high interest debt or even worse, missing car or rent/mortgage payments in the event of an emergency. At least with a 401(k) loan, you’re paying yourself the interest.

Downside #5: You may be subject to taxes and penalties if you leave your job.

Critique: “The better response is for the plan sponsor to amend the plan to permit repayment post-separation. In the 21st Century we call this electronic bill payment. Your response confirms that service providers/recordkeepers have failed to keep pace with 21st Century electronic banking functionality.  The other response is to prepare for any potential change in employment by obtaining a line of credit.”

My Response: I agree that plan providers should offer electronic bill payment after leaving employment, but if your employer doesn’t, you need to be aware of the risk of getting hit with taxes and early withdrawal penalties on the outstanding balance. Also, lines of credit can be cancelled. This is even more likely if you lose your job or if the economy is weak, which are two times when you’ll probably need it.

Downside #6: You’re double-taxed on the interest.

Critique:When you receive a payout of interest earned on investments, it is taxed just like interest on any other fixed income investment. In terms of tax preferences, if you secure the plan loan with a mortgage, the interest you pay on your plan loan may be tax deductible. And, importantly, if the plan loan is secured with Roth 401(k) assets, the interest you pay may be tax free at distribution – just like it would be for the interest received on any other fixed income investment where Roth 401(k) assets were the principal.  So, no, interest is not “double taxed”.”

My Response: I agree with the point about interest from Roth 401(k) accounts not being double-taxed. However, most 401(k) accounts are pre-tax and so the interest will be taxed on the interest when it’s eventually withdrawn. Since that interest was paid by you with money you already paid taxes on, I would call that “double taxed.” That’s one reason why the loan isn’t completely free (the other being the lost earnings from point #1).

Conclusion: The employee I was talking with decided to dip into her savings rather than borrow from her 401(k) due to the double taxation of her interest.

Critique: “Since she could take out multiple loans, there was an “emergency option” even if she borrowed this time. And, assuming the tax status of interest paid to the condo was the same as the tax status of interest paid on a plan loan, the calculation you should have performed was whether, after the loan was repaid, her total net worth (inside and outside the plan) would have been higher. In this case, because the condo rate was 3.75%, she might have been better off using that liquidity option – but nothing in your response suggests you proved which alternative was superior.”

My Response: I do think her choice was the most likely to maximize her net worth the interest she gave up on her savings was less than the the 3.75% the non-401(k) loan would cost her and what her 401(k) could be expected to earn (plus the taxes on her interest payments). That’s why she made the decision she did.

Final point: Finally, don’t forget that the real purpose of your 401(k) is retirement.

Critique: “Your suggestion is that people should avoid using plan assets for any purpose other than post-employment income replacement.  However, if you (self-) limit liquidity, people will only save what they believe they can afford to earmark for retirement.  Those who limit their saving by earmarking money for retirement are more likely to fall short of their savings goals. Importantly, reasonable liquidity access has been shown to increase (not reduce) retirement savings.”

My Response: I’m simply saying that you should understand both the pros and cons before taking a 401(k) loan. In some cases, the 401(k) loan may indeed make the most sense. However, I do think that the 401(k) is not the best vehicle if you’re saving for liquidity. After all, putting your emergency money in your 401(k) could leave you short in an emergency since you can generally only borrow up to half of your vested balance (up to $50k) and the loan will have to be paid back at a time when money might be tight. Saving first for emergencies in something more accessible like a savings account is not going to make or break your retirement.

None of this is to say that 401(k) loans are always a good or bad idea. It all depends on the situation. Just make sure you’re making an educated decision even if it means having a little debate with yourself (or a qualified financial professional).