401K borrowing. Is it smart?
I am a financial advisor. I work with businesses and families to create net worth. I cannot advertise myself or my firm due to regulatory concerns. While I wish that I could call myself a writer, I am not.
When you a hear a question for the 500th time it suddenly dawns on you that this discussion is one surrounded by uncertainty. As an advisor I often get the same questions over and over... Do I start a Roth?.. or stay with a deductible retirement plan? Do I buy Term and invest the difference?.. or bundle my investments within an insurance contract? Should I tell my spouse about my secret account?... (this one is always tricky).
The Topic for today however is the 401K loan. I can't tell you how often this question is asked and so I wanted to take the time to write down my thoughts.
First. The 401(k) represents the majority of positive net worth for clients that I meet with. This isn't always true, but if they had cash or liquid investments then they wouldn't be looking at this account like a starving lion looking at an old gazelle. I am not and never will be for lowering your asset base to buy consumer goods or to finance holiday shopping spree's.
Second. Borrowing from a 401(k) avoids penalties for distribution prior to age 59.5. This is the only benefit to borrowing from yourself. You do have hidden penalties though. You aren't earning dividends, you aren't participating in the growth of the markets etc. The whole idea that you are avoiding an IRS penalty by borrowing isn't necessarily true. From what I have seen, your opportunity cost for not being in the market over a 5 year period is significantly higher than a 10%penalty.
Third. You pay the loan back with after tax dollars. For people who have higher income today than say 20 years ago when you started your 401K... This can mean you are paying a higher effective tax on the money. Translation... you paid tax on the money when you didn't have to.
Fourth. I need to buy a new car anyway. Why not borrow from myself? This often is the greatest justification for the 401K loan. "I was going to borrow anyway." For myself and my net worth I found that when I have debt I tend to pay it off. Also people lose their jobs. This makes your unpaid balances potentially taxable with penalties. Interest rates are so low, borrowing costs are not a sufficient reason to lose out on the market potential.
Last. I have $30k in credit card debt at 29% interest. Should I borrow from my 401K to pay it off? Only after you cut the cards up and close all credit lines. This scenario indicates a flawed use of credit and once you pay it off, you will just pull the cards out again, spend money you don't have, and end up in a doublewide trailer park next to people who smoke menthol's during retirement.
Overall I never think you should borrow from your 401K unless it's an emergency, you are starting your own business, or you have an idea in mind that will grow your net worth at a rate of 15% per year. Buying consumer goods, financing a boat, or other frivolous things are a nightmare scenario in my opinion. Treat your net worth and yourself with respect. You deserve to be financially secure, you don't deserve the newest boat. Your spouse and children deserve to have peace of mind and so do you.