401(k) Loans: Faux Panacea

By John Iekel • October 27, 2017 • 0 Comments
“I shall remember to pay it… to myself.” That’s not just a great line from a bar owner in Casablanca; it’s also a way to characterize 401(k) loans, argues a recent analysis.

In “The Fallacy of 401(k) Loans,” a post by Michael Kitces on the FinancialPlanning.com website, Kitces points out that 401(k) loans may seem innocuous since a participant is taking money from his or her own account and repaying it to themselves, but they still entail risks and costs.

While such a loan may look painless at first blush, Kitces argues “that doesn’t mean a 401(k) loan should be considered part of an investment strategy.” In fact, he says, it is “an exceptionally poor investment vehicle” because of the costs entailed in: (1) the lost benefit of having that money be part of the account, (2) lost tax deductions, and (3) reduced employer matching contributions.

Kitces reminds about the rules governing plan loans:

  • Participants cannot borrow more than 50% of their account balances, except under certain circumstances.

  • If the plan allows it, the employee can take multiple plan loans.

  • The loan must be repaid within five years.

  • Any 401(k) loan repayment must be made in amortized payments.

  • If the loan is used to purchase a primary residence, the plan may extend the repayment period beyond five years at the plan’s discretion.

  • There is no limit or penalty against prepaying a 401(k) loan sooner than its due date.

  • Plans may allow a loan to remain outstanding, and allow a participant to continue following the original payment plan.

  • To the extent a plan loan is not repaid in a timely manner, a default is treated as a taxable distribution.

  • Treas. Reg. §1.72(p)-1 requires that the qualified plan charge “commercially reasonable” interest on a 401(k) loan.

There are some advantages to 401(k) loans, Kitces avers, such as there being no lender taking a risk on the loan and the limit on the amount of the account that can be borrowed. “The appeal of the 401(k) loan is that as long as the balance is repaid in a timely manner, it provides a means for the employee to access at least a portion of the retirement account for a period of time, without having a taxable event — as would occur in the case of a hardship distribution, or trying to take a loan against an IRA — and without any stringent requirements on qualifying for the loan in the first place beyond completing the brief paperwork and perhaps paying a modest processing fee,” he writes.

But Kitces argues that 401(k) plan loans are not a panacea. For instance, he notes, while one pays a loan back to oneself with 5% interest, one is still also losing that 5% interest as well. The net effect, he notes, is that one is really just contributing one’s own money to one’s own 401(k), spelling no growth for the account.

“Is it more appealing to earn a 5% yield by paying yourself 401(k) loan interest, than it is to leave it invested in a bond fund in the 401(k) plan that might only be yielding 2% or 3%?” he asks. In addition, he says, the interest one pays oneself in such an instance is not deductible as either interest or as a contribution. And it will be taxed again upon distribution of funds from the participant’s 401(k) account.

The Bottom Line

While Kitces recognizes that while “there is something to be said” for borrowing from oneself and not from a lender that will charge interest, one must remember that “ultimately, the key point is simply to recognize that paying yourself interest through a 401(k) loan is not a way to supplement your 401(k) investment returns.”

Kitces defers that it is possible that borrowing from other sources could cost more than the revenue lost due to the foregone growth. But he suggests that the best way to evaluate whether one should take a loan from one’s 401(k) is not to compare the 401(k) loan interest rate to alternatives, but to compare the 401(k)’s growth rate to other borrowing alternatives — and since the funds extracted for the loan are not invested, some growth in the account would be sacrificed.

“Borrowing money has a cost,” Kitces points out, adding, “The whole point of saving and investing is to avoid borrowing and instead have the money on hand to fund future goals.” And he argues, “paying 401(k) loan interest to yourself will never be superior to just investing the money.”