Investors are often told that 401(k) loans should be rare, small and brief. Rules of thumb can’t work in every circumstance, but it usually makes sense to leave these retirement accounts alone except in emergencies.
Still, there can be other times when a hefty loan would make sense on paper. If you could borrow at 6 percent or less and invest the loan at 10 percent, wouldn’t that pay off?
It could, but most experts warn against taking a slam dunk for granted. If the investment fails, the loan still has to be paid back to avoid whopping penalties. And the math is not as simple as it might seem at first. A 401(k) loan is generally limited to half the account value and a maximum of $50,000, with interest often around 1 percent over the prime rate (currently 4.5 percent.) Loans usually must be repaid within five years.
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“Accessing your future income stream for current investment is an extremely risky investment strategy,” says Kevin Ward, president of Park + Elm Investment Advisers in Indianapolis.
“People typically stop contributing to their 401(k) while repaying a loan, which means they are also missing out on their potential employer match,” says Andrew Thomas, director of client services at Blooom.com, a 401(k) advice site. “These are huge setbacks to the average American, and there are many other better options to consider before dipping into your nest egg early. With a 401(k) loan, you are literally taking the money out of your 401(k) by selling invested assets, thereby losing the power of compound growth on those assets.”
The biggest issue is that loans for risky investment violate the purpose of a 401(k). These funds are meant to provide tax-favored investments for retirement, to be left alone to grow for many years and to offer investment choices that are promising over long periods. Tapping a middle-of-the-road stock and bond fund to speculate on bitcoin could make you rich or leave you pinching pennies in retirement — or worse.
Investors who are tempted by easy loan standards and low interest rates should keep in mind the destructive temptations 401(k) loans can spark. “This is about human behavior,” Ward says. “If you need a loan from your 401(k) for any reason, you might not be saving enough outside of it.”
Borrowers can also be tempted to stop contributing to the plan, he adds. That would stunt results going forward.
Experts say investors meeting the devil at the crossroads should keep a few things in mind.
“Paying yourself” isn’t what it seems. Anyone considering 401(k) loan might be drawn in by the fact that the interest paid will go back into the 401(k) account, not some lender’s coffers. While this is true, the money returned to the account generally must come from a source subject to taxes. So a loan means taking out money that was probably sheltered from tax when it was put in, and replacing it with money that’s left after tax was paid. This amounts to a tax on the loan. You may have to earn $10,000 to repay a $7,500 loan, assuming a 25 percent federal income tax.
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There is opportunity cost. That refers to the return that could have been earned on holdings that were sold in the 401(k) to come up with the cash for the loan. If they could earn 10 percent, and the interest charge would add another 4 percent, it obviously wouldn’t make sense to borrow for an investment that would earn less than 14 percent.
“Our stance is to only use a 401(k) loan as a last resort,” Thomas says. “The biggest drawback to these loans is opportunity cost that comes with the missed potential growth of your investments.”
Risks can be too high. The math may work only if the new investment is a home run. But big returns often signal big risks. And if you’re used to buy-and-hold investing strategies in your 401(k), you may not be equipped to spot stellar opportunities outside the account.
Your account options are just fine. Fortunately, 401(k)s have improved over the years, and many plans now offer a wide range of investments suitable for investors who want a riskier path, or a safer one. Sure, there are many more options outside the account, but are they really so much better than ones you already have?
Entangling your career choices. Most plans require that 401(k) loans be paid off upon leaving the company. If you can’t come up with cash, the plan may sell off assets in your account, even if it’s a bad time to do so because of a market slump. Or you may have to sell your alternative investment at a bad time to repay the loan. Imagine if you lost your job due to a recession, then took a big loss in your retirement account. You might never recover.
“You could be stuck with early withdrawal penalties, or simply stuck at your job,” Ward says. Most withdrawals before age 59 1/2 are subject to income tax plus a 10 percent penalty.
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Thomas says a 401(k) loan can be useful in extreme circumstances, but that doesn’t include investing.
“Appropriate reasons to take a 401(k) loan would be to pay back taxes or tax liens or to avoid bankruptcy,” he says, noting that retirement accounts are typically shielded from the bankruptcy process.
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5 Reasons Why a 401(k) Loan Rarely Pays Off originally appeared on usnews.com
