Retiree Portfolio 401(k) Loans: Worth It?

401(k) plans typically feature a loan provision that is popular with participants. Should you be tempted by this "feature"? Not necessarily. While borrowing money from a 401(k) plan is fairly easy, it can lead to significantly fewer dollars in retirement. Therefore, such loans should be made only when all other options to satisfy a financial emergency have been exhausted. Otherwise retirement resources may be needlessly limited.

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By David Braze (TMF Pixy)
December 18, 2000

Most 401(k) plans have a loan provision that allows any participant to borrow up to one-half of her account's vested balance or $50,000, whichever sum is smaller. This feature enables you to borrow money from yourself, and pay interest back into your account, not some lender's, as you repay that loan.

Sounds like striking gold in your own backyard, doesn't it?

Of course it does. And employers (anywhere from the 56% to 90% of them who offer this feature, depending on the data you cite) would love for you to know about this plan option. You see, loan provisions are allowed in 401(k) plans because employers and our legislature believe that option encourages employee participation in the plan. If employees are aware that in a pinch they can get at their money before retirement, then they will be more likely to contribute to those plans. Indeed, a 1997 General Accounting Office (GAO) report indicated that "plans that allow borrowing have a somewhat higher proportion of employees participating than other plans, all other factors being equal, [because] allowing borrowing increases participation among eligible employees, especially lower-income employees." Further, "participants in plans that allow borrowing contribute, on average, 35% more to their pension accounts than participants in plans that do not allow borrowing."

So, I guess we can conclude that 401(k) loans are a good thing, right? Well, maybe so. But then again, maybe not. It really depends on why a loan is necessary. Let's see what I mean by looking at the pros and cons of 401(k) loans. In no particular order, we can say the good aspects of 401(k) loans are:

• The loan is virtually guaranteed. If there is a vested balance in the account, the participant may borrow money.

• Loan interest is invariably lower than that obtainable elsewhere because it is usually set by the plan at slightly above the prime rate.

• Loan procedures are quick and easy in most cases, and often involve little more than the completion of a simple form.

• Repayment is a breeze because required loan payments will almost always come out of the borrower's paycheck automatically each time that person is paid.

• The interest paid on the loan goes directly into the participant's account, not to someone else. In effect, then, the borrower receives an interest-free loan. The fact that loan was funded from money already owned by the borrower is immaterial.

Just in case those good features make 401(k) loans seem attractive, here are some of the drawbacks, again listed in no particular order:

• Loan repayments are made with after-tax dollars. That means someone in a 28% marginal income tax bracket must earn $139 for every $100 made in loan payments.

• Interest payments are not tax-deductible, and they will be considered as earnings within the account. As earnings, they will be taxed again when the 401(k) plan proceeds are finally distributed in retirement.

• The burden of repaying the loan often means the participant cannot afford to maintain the same level of regular contributions. That means the account will not continue to grow at the same rate as before the loan. It could also mean the loss of employer matching contributions.

• Loans usually must be repaid within five years (up to 30 years if used for the purchase of a principal residence). However, if the borrower leaves that job or if the plan gets terminated for any reason, usually the loan must be repaid in full within 90 days. Failure to do so causes the loan to be in default. The IRS considers defaulted loans as "deemed distributions." That means the borrower must pay income taxes on the amount not repaid. If the borrower is younger than 59 1/2, he or she usually will have to pay a 10% excise tax for an early distribution as well.

• Although interest on the loan is paid directly into the borrower's account at a reasonable rate, chances are the participant could have earned a better return had the borrowed money remained invested instead. Additionally, while the loan money is out of the 401(k) account, it loses all the compounding of returns it would have earned had those funds not been removed. Both effects mean less funds at retirement.

That last point was amply demonstrated in a 1997 General Accounting Office (GAO) report. That study looked at a hypothetical person who participated in a 401(k) plan for 35 years using an investment that earned 11% annually. Starting with a salary of $25,000 that increased through the years at an inflation rate of 3%, the report simulated a $40,000 loan in year 15 that was repaid in equal installments over 10 years at various interest rates. (Note: Assume the loan was for a principal residence.) The simulation looked at what would have happened under three scenarios: 1) If the loan had not been taken at all, 2) the loan was repaid while regular contributions continued, and 3) the loan was repaid while regular contributions were suspended. The results of this simulation are shown below.

                 Simulation Results

               Account          Percent of
              balance in         no-loan
               year 35           balance
  
If loan was not taken                                


               $952,977           100.0%

Maintain contributions to pension account during loan
6.3% loan      $892,209            93.6%
7.0% loan      $900,892            94.5%
8.0% loan      $913,526            95.9%
9.5% loan      $932,968            97.9%

Suspend contributions to pension account during loan 
6.3% loan      $687,863            72.2%
7.0% loan      $696,546            73.1%
8.0% loan      $709,180            74.4%
9.5% loan      $728,622            76.5%

Note that in every case a loan resulted in fewer dollars in the account at retirement. That loss was particularly severe when loan repayment caused regular contributions to be stopped while the loan was outstanding. We could quibble about the size of the loan and the amount of time used for repayment. Even so, a similar result would prevail for smaller loans and shorter repayment periods as well. Simply put, a loan causes fewer dollars to be available in the 401(k) at retirement.

My conclusion? 401(k) plan loans may serve a purpose. But when used, they will also limit the borrower's financial resources when that person reaches retirement. Therefore, they should be used as the loan of last resort. If you're a homeowner, get a home equity loan first. At least that vehicle will give you a tax deduction for the interest you must repay. On the other hand, if your only option to satisfy a financial emergency (or to rid yourself of onerous 18% or higher credit card debt) is to take either a hardship distribution or a loan from your 401(k) plan, then the loan is better. The hardship distribution will always result in taxes. And, depending on your age, it could result in a 10% early withdrawal penalty as well. A loan won't be taxed or penalized unless it's not repaid.

See you next week. In the interim, post away on either the Retired Fools or the Retirement Investing board. And remember -- your posts result in a contribution to the Foolanthropy drive, so post often. You might even want to consider making your own charitable contribution, too. After all, there's only 13 more days to earn an income tax deduction on this year's tax return for that purpose.

Best to all...Pixy