Slight was the thing I bought,
Small was the debt I thought,
Poor was the loan at best–
God! but the interest!
Are you sitting in a kitchen that was built back in the flyaway collar heydays of about 1973? Dying to upgrade the appliances, strip the wallpaper, get rid of the cabinets, knock out some walls, and just open everything up?
You talk to some contactor friends and find out that your fancypants kitchen schemes are going to cost you about $20,000. Hey, it’s an investment, right? It should pay itself back, right? At least, that’s what you rationalize to yourself to provide the justification for tapping into the piggy bank to pay for the upgrades.
Then, you realize that you don’t have an extra $20,000 lying around. Hmm. Now you’ve convinced yourself that you really need that kitchen upgrade because it’ll make every dinner you cook taste better.
You start poring through your assets and, lo and behold, you have $100,000 sitting in your 401k account. The 401k loan rules for your employer allow you to take a loan and your 401k loan interest is reasonable – it’s the Prime Rate plus 1%.
At this point, Monkey Brain decides to pipe in. He doesn’t know much about investing, but he knows this:
Monkey Brain: “INTEREST RATE ON 401K LOAN GETS PAID TO YOU. MAKE MONEY ON UPGRADE KITCHEN. MAKE BANANAS INTO BANANAS FOSTER!”
Ooh! Now you’re thinking that you get to double dip. You get a new kitchen and you get to earn money at the same time, giving yourself a guaranteed return on your “investment.”
Aww, man! Why do I have to go and break up the party like that?
Let’s look at the reasons why you can’t borrow your way to riches using your 401k as your piggy bank.
Reason #1: You’re converting pre-tax dollars into after-tax dollars
When you put money into your 401k, that money came from your pre-tax dollars. A contribution to your 401k reduces your taxable income in the year that you make the contribution. Once you withdraw that money in the form of a loan, you’re going to have to pay the money back with after-tax dollars – namely the ones that arrive in your bank account via paycheck.
Now, there is some misconception about the taxation of 401k loans that needs to be cleared up. You aren’t converting the principal into after-tax dollars. You just spent $20,000 of pre-tax money to upgrade the kitchen. You’re putting that money back. You could have used after-tax money to upgrade the kitchen. Therefore, that’s a wash.
Where you do convert pre-tax into after-tax dollars is when you pay back the interest. You’re going to have to pay in excess of $20,000 to repay the loan. Where’s that money coming from? Your bank accounts, which have already been taxed.
Reason #2: You’re being taxed twice on your 401k loan interest
You’re taxed once on the money that you earned in order to pay back the loan in the first place. When you withdraw your funds from your 401k in retirement, those withdrawals are taxed at your ordinary income tax rate, as opposed to a capital gains or dividend income tax rate. Thus, you’re taxed once when you’re putting the interest payment into your 401k, and you’re taxed again when it comes back out.
Let’s say that the current Wall Street Journal prime interest rate is 3.25%. Your 401k loan interest rate is prime + 1%, so that means the interest rate you’ll pay on your 401k loan is 4.25%. Let’s say, furthermore, that your effective tax rate is 25%.
You borrow $20,000 to make that kitchen all spiffy and new, and you have 5 years to pay back the loan.
How much will you have to earn per month to pay off that loan?
Your payments will be $372.86 per month, but you’ll have to earn $497.15 per month in order to have the $372.86 in the bank account to pay yourself back. You can’t use 401k contributions to pay that 401k loan back.
Put another way, you’re zapping 25% off of the 4.5% interest that you’re paying yourself. Therefore, you’re only earning, after taxes, 3.375% interest on your 401k loan.
Furthermore, you’ve exposed yourself to another financial risk that’s unique to the 401k loan.
Reason #3: If you default on your 401k loan, you’re heading for a large tax bill
Your 401k loan program will have terms for catching up if you miss a payment. This is called the cure period. Miss your payments beyond the cure period, and you’ll be considered in default of your loan.
Once you’re in default on your 401k loan, the Internal Revenue Service will consider the loan balance as income, and you’ll have to pay taxes at your ordinary income tax rate. Additionally, if you’re under age 59 ½ (or age 55 if you quit working, see IRS Publication 575), the loan will be considered an early distribution, and you’ll pay a 10% penalty on the balance. Here’s hoping that you didn’t plow all $20,000 into the kitchen!
Of course, this assumes that you work for the same company for the five years of loan repayment. It’s another risk.
Reason #4: If you leave your employer, you accelerate the loan repayment period
It doesn’t matter if you left, you were marched out the door by security, or the company went belly up. The Internal Revenue Service’s response to your dilemma is “frankly, my dear, I don’t give a dayum.” You have sixty days from the time you leave your employer to repay the loan in its entirety, or you’ll face the same tax and penalty consequences as you would have had you defaulted on the loan. Effective, if you don’t pay the loan back in sixty days, according to the Internal Revenue Service’s rules, you have defaulted on the loan.
Let’s look at what happens to you if you decide to be an intrepid saver and save up to pay for the kitchen upgrade instead of using a 401k loan. Will you be better off in the long run for having not “paid yourself” the 401k loan interest?
Assume that you’re Harry Householder and you’re making $75,000 per year in salary. You contribute 6% a year to your 401k, and your employer doesn’t match. I know. Most employers match some level of 401k savings, but I want this example to be skewed as much in favor of the loan as possible, so by saying no match, I’m removing some of the benefit of keeping the money in the 401k. Since you believe in the Dave Ramsey 15% savings rule, you save another 9% of your salary in after-tax investing accounts (yes, I know, you’d normally want to contribute to an IRA, but that kitchen is calling your name!). This means that $375 a month goes into your 401k account and $562.50 per month goes into your other savings and investing account. If you take out a loan, you’ll reduce your after-tax savings by the amount required to pay back the loan. If you don’t, then you’ll buy the kitchen once your after-tax savings account hits $20,000. Up until now, you haven’t put anything away in after-tax accounts, but you’ll start today.
Let’s further assume that you get a 9.87% average rate of return, which is the compound average growth rate (CAGR) of the S&P 500 since 1926. This applies for 401k and for after-tax investments.
If you get a loan, you’ll pay 4.25% interest over 60 months. The payments will be $372.86 per month, leaving you with $189.64 to save in your after-tax accounts and still keep within your 15% of income saving and investing guidelines.
There are two questions we want to answer.
How long do I have to put off getting that awesome new kitchen if I save up for it?
The answer is 32 months. After 32 months of saving up, your after-tax savings balance will be $20,540.92. Hello granite countertops!
Which one leaves me better off in the long run?
After five years, the difference in net worth is $7,332.11.
After twenty years, the difference in net worth is $30,089.47.
The reason for the difference, you might pose, is that you’re not changing how much you save. What if you were planning on taking out a HELOC or a personal signature loan (by the way, I’m not a fan of debt in case you didn’t know), so, instead, you’re “forcing” yourself to save that interest by taking it out from the 401k? Does that make a difference?
Ah, tricky one. There’s one problem. If you were going to take out the loan to make the payments, you should, instead, save an extra $372.86 per month and buy the kitchen that much faster!
As long as you save up the same amount for the period of what the loan would have been, then you’ll be better off and you’ll have your kitchen in 20 months. If you, after buying your kitchen, and hop on the hedonic treadmill, spending the $372.86 per month rather than continuing to save it for the remaining 40 months, then, yes, the extra 40 months of forced savings will play to your benefit.
Taking out a 401k loan to force yourself into saving more is a risky proposition. By creating a Ulysses contract, you could wind up better off because you’re lashing Monkey Brain to the mast of forced savings by threatening him with an enormous tax bill, and the one thing that Monkey Brain hates more than delayed gratification is having to pay more taxes. There are better ways to create that Ulysses contract and force yourself to save more, and by doing so, you will probably get a higher rate of return than the effective after-tax savings rate you’d get on the interest on your 401k loan.
Borrowing money from your 401k does not make sense because it will generally provide a lower return and you may expose yourself to a potentially high tax bill. You’re better off saving up for whatever it is that you want to purchase and continuing to save afterwards.
Have you ever taken out a 401k loan? What was your experience? Were you glad you did or do you wish you’d just saved up instead? Tell us your story in the comments below!
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Around a year ago, I wrote about practicing what I preach and going to Chile. If you haven’t seen it and are curious about Chile (yum, wine), go check it out!