I have a divorce related payment coming up soon and a textbook example of a finance question came up. Is it better to borrow the money to make the payment or is it better to just use the cash I have on hand?
If you Google, how to use a 401(k) loan, the internet all that seems to come up are cautionary articles about how borrowing from your 401(k) could leave you with less money for retirement. Yet I couldn’t come across any reading that described how to take a 401(k) loan responsibly, so I thought I would write it here.
Conventional Wisdom
Most pundits and financial literacy writers advise you not to take a 401(k) loan for a simple reason: many of the people that tap them are not doing the best things with the money. They may be financing a lifestyle that is above their means or covering expenses for an emergency. The issue is once you put yourself in that hole, if the funds don’t get paid back, you could incur a 10% penalty and have to pay taxes.
In addition, you pay interest to yourself. This may sound good but many times the rate is lower than what you would have gotten in the stock market. For example, let’s say you take a $20,000 loan out and pay it back over time at a 5% rate of interest. You may end up with a little over $25,000 after 5 years but at a 10% compounding rate, you could have grown that to a little over $32,000. Since the value of compounding over time is what early saving aims to capture, that difference could cost you tens of thousands of dollars down the road.
So this is why most commentators on this topic have advised against 401(k) loans. It’s just easier to advise people to stay disciplined and stick to their retirement guns.
An Alternative Approach
Yet another was to look at it is this. Let’s say you are a diligent saver and make about $60,000 a year. You manage to put away about $1,500 a month which nets you about $18,000 in savings a year. That $18,000 comes at the cost of saying no to splurging and big expenses to keep your eye on your goal of saving.
In addition to this saving, that same worker may contribute $3,000 (5% of her salary) towards a 401(k) and with a company match up to 5%, can put away about $6,000 a year. Not bad.
But what if you were to flip this logic on its head and do the opposite. In this I mean, plowing a ton more into your retirement and very little into your personal savings with the aim towards borrowing some of that at a future date. In the example I gave above, over the course of three years, rather than putting away $54,000 through saving and $18,000 towards your 401(k), you max out your 401(k) at $19,500 annually, along with your $3,000 match giving you $22,500 annually. Multiply this over 3 years and you will have put away $67,500. Maybe after this you only manage a little private savings, about $6,000. Of this 401(k) amount, most plans will let you borrow up to 50% or $50,000, whichever is lower. So this person would borrow $33,750 from their plan.
If this person was contributing money pre-tax into their 401(k) then now they have a sum of money that has never been taxed. If we assume they are a disciplined investor, they could then go on an invest those funds in the market while paying back the 401(k) loan from their future income. What this does is essentially leverage their future income to the present. Their future income is reduced through the loan repayment, but the savings from the future is now an asset in the present. If you understand the time value of money, you can see why this is valuable. Even better that the interest is paid to yourself. This is best shown with an example.
The table above has 2 scenarios. On the left is a scenario where someone focuses on stashing away more in their personal after tax savings and a little in their 401(k). The assumption in all cases here is that anything saved is invested in the stock market and grows at an annual rate of 10%.
On the right, this assumes that someone invests the majority of their savings in their 401(k) with the aim of eventually taking out a 401(k) loan in the future. For simplicity, I assume that there are no raises or promotions, this person just stays in the same role saving $24,000 per year for 10 years.
As you can see, the situation where the person on the left borrows, actually comes out with more overall cash at the end of the 10 year period. The trade off for this is that there is less after tax cash overall and the difference between them is about $16k. The reason for this difference is that $50k was simply shifted from one account to the other but that $50K was then compounding at 10% just like it would have in the other account, the difference is that there are no more after tax savings. The $24K saved goes all towards the 401(k) in the form of loan repayments and contributions. Contributions in this case had to be lowered to pay back the loan but the total amount saved remains the same. The only difference is that instead of waiting for 5 years of $125 saved a month, you have the money up front and it is able to compound over those 5 years. Add to this the 5% interest paid to themselves via repayment and you end up with more money overall at the end thanks to a bit of the effect of leverage.
To look at it another way, if the same person on the left never took out any 401(k) loan and just saved $125 a month for 10 years invested at a 10% annual growth rate, they would have $23,906 at the end of the 10 year period as opposed to $95,274.
So what would we have had total if this person just plowed all their savings into the 401(k) or personal savings? The answer is $406,404 or about $8,000 more than the second scenario. Yet the inherent disadvantage to this is that one account will be non-existent either your personal savings or your 401(k). Never taking the loan at all in the high retirement saving account would yield $358,592 in retirement savings but only $23,906 in personal savings. So more retirement money yes, but less overall. taking the loan reduces retirement savings by $55,149 but adds $71,368 to personal savings.
Take Advice With a Grain of Salt
The point of this exercise is to show you that there are various ways to use the retirement and brokerage account vehicles we have in order to save. Having the ability to plan and be disciplined is always a skill that will pay off in the long run when it comes to money.
Financial advisors and columnists know that many people tend to have a bid called mental accounting where they may be less likely to use 401(k) money as it is mentally locked away for retirement. If you are willing to leave that bias behind though, you can stealthily move money between accounts over time and even come out with more money in the long run.
This isn’t advice for everyone, if you are not disciplined with your money and don’t have emergency savings for life’s eventualities like losing a job, then it isn’t for you. The example I presented was a simplified one. I didn’t even get into the tax benefits of this strategy as you can have the option to take 401(k) contributions out pre-tax. When you retire those funds are usually taxed like wages so are taxed at a higher rate whereas your personal long term investments will be taxed much lower. I did not get into the weeds of whether this nets out due to the lower contributions that need to be made for the last 5 years while the loan is being repaid with after tax cash but is an angle to potentially consider in another post.
If you have ambitiously saved for retirement, rather than scaling back your contributions, a 401(k) loan may be the best option for you as long as you are investing the proceeds and consistent. Know that there is another way but proceed with caution.
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