401k Loan – Podcast Episode 466

by | Dec 22, 2023 | Podcasts

401k Loan – Podcast Episode 466

Key Takeaways:

– The podcast episode discusses an article from 401(k) Specialist, and sponsored by Principal Financial Group, which aims to debunk myths about 401k loans, suggesting that they may not be as negative as commonly perceived.

– The hosts, Tim and Tom Mullooly, express skepticism about the article’s intent and discuss the importance of managing cash flow and budget to avoid needing a 401k loan, rather than viewing such loans as a convenient option.

– They address myths from the article, such as 401(k) borrowers frivolously spending loan money, the demographic of typical borrowers, and the consequences of defaulting on a 401k loan, emphasizing the importance of understanding the implications of taking out a 401k loan.

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401k Loan – Podcast Episode 466 Transcript

Welcome back to the Mullooly Asset Management podcast. This is episode number four hundred and sixty-six. I’m Tim Mullooly. With me today is Tom. Tom, what are we talking about today? Fake news, fake or misleading news. Yeah, I don’t like it. We stumbled across an article in 401k Specialist, and it was about 401k loans and their intention to debunk some myths. We’ll link to this whole article in the show notes if you want to read it, but we’re going to break it down step by step and dissect what they’re saying.

I think it’s important to note that this was a sponsored article, sponsored and written by Principal Financial Group, which does a massive amount of 401k plans. So, first off, I think that’s important. Sometimes you go to these websites, and the majority of them are from journalists writing just informational pieces, but every once in a while, these websites slip in a sponsored post. And you have to think about what the author is doing when they write it or the tone, the side of the fence that they’re sitting on.

To be fair, 401k Specialist is an industry magazine, well, an online magazine, that we get daily junk mail from. And it’s funny when you look for the author line. What does that say? It says by Principal Financial Group. That’s astonishing. Yeah, I think so. Having that information going into the article made me read it through a different lens. They wanted to debunk some myths about 401k loans; essentially, the tone of the article seemed to be that there were a lot of negative connotations or misconceptions about taking 401k loans or the data surrounding the loans of who’s taking it, how many people are taking loans, and so on.

To me, it kind of felt like they were not encouraging people to take 401k loans but almost giving permission, saying like it’s not as bad as people think.

Yeah, I think they were trying to remove some of the guilt and shame that sometimes comes along with taking a 401k loan. And so they start out the piece by talking about how, since the pandemic, more and more people are taking loans from their 401k.

It doesn’t hurt that the balances in their accounts are up probably forty percent since the start of the pandemic. Well, unless they’re all in bonds. Right. Well, it makes sense, you know, going through the time of the pandemic when people were losing their jobs or the economy was bumpy, and money became an issue for people. The one place they could potentially turn to is their 401ks to get some quick cash.

I think the problem is that while Principal talks about how easy it is to gain access to this money, it’s a loan, and loans need to be paid back. Yeah. And so while you might get a quick fix by taking thirty or forty thousand dollars out of your retirement plan, you are signing up for sixty payments over the next five years. I don’t know. Yeah, I think 401k loans can be a useful tool for people if they absolutely need to take money in a dire circumstance. But I don’t think it’s as good of an option as they potentially paint it out to be in this article.

So they walked through a few myths. What was the first one that they had? The first one that they discussed was that 401k borrowers are frivolously using the money that they take out in a loan without care for their retirement plans. And then what they retort is that the data shows that most loans are used responsibly to pay off debt and essential expenses, while saving for retirement continues to be a priority. A lot of people have it drilled into their heads that saving for retirement is necessary. You have to do it. Why aren’t you saving for retirement? How much are you saving for retirement? It just continues to be a priority for people.

And I read this myth as, you know, they’re taking a 401k loan and they’re still putting money away for retirement, and they try and make that seem like that’s a good thing.

They’re still able to put money away for retirement. But if you take a step back, it’s like, well, why did they need to take this 401k loan in the first place? They needed money. So if they maybe if retirement wasn’t as high of a priority on their list, they wouldn’t have been piling as much money into the 401k as they were. They would have had more money in their paycheck. I think the financial priorities for a lot of people are out of whack. And that kind of almost all of the myths in this article, that was my takeaway.

It’s like, well, if they didn’t have to take a 401k loan in the first place because they were managing their cash flow better, managing their budget better, or right-sizing how much they’re actually putting into this 401k in the first place, they wouldn’t be in this position. So I think that’s, for me, that was like, well, 401k loans aren’t the boogeyman. They’re not bad. And if you need to take it, take it, but like, try not to put yourself in a position where you need to take one.

That should be the first step, in my opinion. I completely agree. I think that if you’re taking a 401k loan or some type of loan from your retirement plan, it’s because you have a cash flow problem. Right. It’s because you don’t have an emergency fund. And as we go through each of these myths that they talk about, the answer comes back over and over. This is a cash flow problem. This is you didn’t have an emergency fund. You didn’t have savings in reserves.

So many people start their job or their first job, say they’re in their early to mid-twenties, somebody tells them the first week that they’re working there, “Hey, sign up for the 401k. And put as much as you can in because that’s going to be really important.” Yeah. You know, Social Security isn’t guaranteed, right, according to some guy by the coffee pot. Right.

You know, you’re on your own for retirement. There’s no pension anymore. So you’ve got to save everything that you can, and people get scared into saying, “My goodness, I better put like ten percent or twelve percent of my entire paycheck into this,” and then they find out that they’re going to buy a house and they don’t have the cash. Yeah. It’s a problem. Right.

One of the things before we get too far into this, I thought it was clever that Principal had this little illustration on the first or second page. We’ll link to this in the show notes.

How they try to blame that increased loan requests came with inflation. Right. Visually you can see they have the percentage of loan requests and then how inflation, the percentage of inflation over the years from 2019 through 2021, 2022, and now the first half of 2023. That is the most recent data that they had. But it doesn’t illustrate the point I think that they thought it did because the loan request percentages each year go from eight to seven to eight percent to nine percent. Right.

While inflation is moving from two percent in 2019 up to seven percent in 2021 and 2022. And now the loan percentages drop in 2023 along with inflation, but I just, it doesn’t line up or make the point I think they were trying to. Yeah. It doesn’t. They can’t blame this on inflation. Yeah. Uh, and I think that’s really the takeaway.

So, uh, they also tied in this survey from the Employee Benefit Research Institute, uh, in our business, it’s known as EBRI. Uh, survey last year, workplace wellness survey, showed that there’s a problematic level of debt including credit cards, medical expenses, and student loans, and that’s where people are tapping into 401k loans. Right.

We try and counsel folks that if they’re considering taking a loan from their retirement plan. If it’s an urgent need, well, you know, you got to us kind of late. There’s not much we can do if you’re, you know, if there’s an arrow stuck in your neck. Right. You’ve got to address that. Yeah. But if it’s something like, “Oh, I want to pay off my credit card.”

Uh, we’ve done, I’ve lost count of all the videos and podcasts that we’ve talked about where you didn’t get forty thousand dollars in credit card debt overnight. It rarely happens that way. And so you can tackle the problem the same way. And one of the things that we do say to some folks if they’re in a job that pays well and they have good cash flow, that maybe what they ought to consider doing for a year or two is not contributing to their retirement plan. Principal would never say that.

Right. Uh, maybe they should just take the money that they were driving towards their retirement plan and take that money and pay off Mr. Visa. Yeah. It’s difficult because I think like you said, sometimes these things happen or, uh, the debt has already been accrued. And there’s not much you can do about it. And then once you’re in that boat, it might make sense to actually take a 401k loan so that you can pay one lump off because your credit card’s compounding at twenty-nine percent, uh, and this loan that you’re going to take from the 401k plan is, you’re paying it back at five, six, seven percent.

Uh, so you’re trading, you’re trading debt at that point, but you’re just lowering the interest rate. So at that point, it could make sense. Uh, but like you’re talking about, I mean, interest rate arbitrage, yeah. You try and head off these problems before they actually occur. And I think that’s the main point. Um, but I guess it’s good to hear that people are not frivolously spending the 401k loan money.

Like that part of the point is good to hear that they’re using it for, uh, things that are important.

So when we talk about 401k loans, and I know we’re kind of veering off from the article, but the maximum that you can take from a 401k or other retirement plan is fifty thousand dollars or half the balance of the plan. So if you have less than fifty thousand dollars, say you’ve got forty thousand dollars, the most you could take would be twenty, half of the plan. The maximum dollar amount you can take out is fifty thousand dollars.

So fifty thousand dollars, I’m, I don’t have a calculator with me, but current rate of interest on a loan like that, you are talking about if you take the max fifty thousand dollars because you want to use it as a down payment on a vacation home, second property, a car. I don’t know. Uh, but you’re talking about a monthly payment, sixty equal payments of something in the neighborhood of fourteen hundred dollars a month.

And so I am again going to use the word astonished when I see Principal say that a strong majority, eighty-three percent of people, continued contributing to the retirement account while taking a loan. Well, how do you afford that? I mean, the point being, they said it, they’re contributing at the same deferral rate.

So they were deferring, let’s say, ten percent, whatever, into their 401k. And then they take a loan and then they continue sending in ten percent into their from their paycheck into the 401k.

To me, that’s probably part of the problem. They paint it as that that’s a good thing for people. Um, but for plan traders, yeah, I mean, it’s good that I guess it’s good that people are saving for retirement, but if it comes at the cost of their current cash flow needs, then another thing that we always talk to people that try and do what we illustrated before, where you take a lump sum to pay off credit card debt, it’s a one-time hit to wipe the slate clean, but it doesn’t fix the behavior that got you into that mess in the first place.

Um, so a lot of times we see people, you know, do something like this to pay off a big lump sum. Uh, and then a few years down the road, they’re back in the same boat. So I think like we’ve said a few times here, it’s fixing the behavior and fixing the issues ahead of time so that you don’t put yourself into this position. Yeah.

The one-time bailout hardly ever works. Yeah. It’s putting a band-aid over, but it’s not actually fixing the issue of like what caused the pain. You have a spending habit or you have a cash flow problem in general that needs to be addressed. Yeah. And we try and get folks to once they clear up all this loan business to maybe scale back what they’re putting into a retirement plan and start building up a reserve on the outside. Right. Uh, where they can deal with a significant health expense or a car repair or some kind of situation where they’re going to need cash right now.

Right. So that’s a problem. Yeah. Okay.

So the second myth that they were trying to break in this article is that loans are mostly taken by younger and lower-income participants who use them like a revolving credit line. Yeah.

They went on to say that the data pointed out that the average 401k borrower is age forty-three. About the time you start getting a significant balance in your plan. Yeah. We were talking about this before the microphone turned on, and I likened it to when there are statistics saying that you get in the most car accidents driving within a five-mile radius of your house. And it’s like, well, yes, because that’s where you do most of your driving.

It’s like the statistics are kinda, you have to bend your brain around it for a second. It’s like, of course, most of the accidents happen where you do most of your driving, and it’s the same thing with this myth. It’s like, the people that actually have been putting money into their retirement accounts for a long time and have money to take out of their retirement accounts are the ones taking money out of their retirement accounts? No way. That’s crazy.

You mean the twenty-five-year-old who just enrolled in their 401k six months ago and has seventeen hundred dollars in there isn’t raiding their 401ks for?

Don’t laugh, you and I have seen that. We have!

But it’s like, you’ve got to be kidding me. That’s not the majority of the people. Wow. Yeah. Crazy groundbreaking stuff. Yeah. So another myth that they talk about is that many 401k borrowers will leave the company, default on their loans, and this puts them at risk of being assessed a penalty and taxes, and creates an additional administrative burden for the employer. That’s not a myth.

In fact, all of the things that they said in that run-on sentence are pretty accurate, but they’re just saying what they put in front of that statement was, “Most people who take loans are planning on leaving the company.” No. Yeah.

But if they do default on their loans, they will be assessed penalties, they will be assessed taxes, and it does create administrative burdens for the employer.

So all of that is true. Yeah. And when you go back to some of the other points that they made, um, that people aren’t spending this money frivolously, which is a good thing.

But the 401k loans being taken are being used for important things. So you would hope that the people taking the loans are at least doing their research or they anticipate paying back the loan and you know they wouldn’t get themselves involved in something like that frivolously, to use their own word. Right.

So, yeah, that makes sense to me. And that’s a good thing to hear. You don’t want to see people, uh, just taking these loans all willy-nilly and then leaving and getting themselves into an even bigger mess. It is worth talking about what happens when people do leave the company or if they default, how do you default on a loan like that? And will that affect my credit score? These are real questions that we can ask.

Yeah. If you default, uh, you missed a payment. Usually, most plans have a certain number of payments that you miss. Some are very strict where if you miss one, you default on the entire thing. And then the rest of that loan that you haven’t paid back yet becomes fully taxable. It’s like you took a distribution from your 401k. So it’s taxable.

And if, you know, you’re penalized on top of that too. So if you’re under fifty-nine and a half, you’re going to be paying ten percent on the distribution, and you’re going to get a 1099-R the next year for taxes owed. And that’s the worst part is that say you took this money, this lump sum of money in a loan to pay off a credit card. You don’t actually even have the cash. Right.

And then when you get assessed the penalty, you’re going to have to pay out of pocket for that. Yeah.

So they made some points in the article I think that were technically correct. And if you do find yourself in a position where you have to take a 401k loan, what they were saying is true and it makes sense. My issue with it is that it doesn’t address the fact that there are so many things that you can tweak in your own cash flow and budget and personal financial situation to avoid having to take a 401k loan in the first place.

Yeah, I think a lot of people misunderstand or never stop to learn all of the ins and outs of these retirement plan loans.

So when you do take a loan from your retirement plan, that money is coming out of your investments. It’s coming out. When you take forty thousand dollars out or fifty thousand dollars out of your plan, for the next period of time while that loan is being repaid, that money is not doing anything for you.

And I know this came up in our last discussion as well. So when you take the money out, you pay yourself some interest, but you’re also paying the plan administrator for the cost of the loan as well. It’s, I cringe when I hear people say, “Yeah, but you’re paying yourself.”

You’re not paying yourself the whole thing. Right. And so the typical rate of interest that you’re charged is for many plans, prime rate plus one, and it becomes a fixed rate on the day you take the loan out. It’s not a variable rate like a Visa card.

So right now, prime rate at banks in the United States at the time we’re recording this is eight and a half percent. So you are now paying nine and a half percent out of post-tax cash flow. You have to have the money sitting in a bank, so you can pay it back each month. Most times when you’re doing a 401k or retirement plan loan, you can’t do it through your payroll. Right. It has to be through a bank.

So you have to have the cash to pay back your own loan. The loan that you took with pre tax dollars. Correct. Most likely. Now down the road, when you retire and you take money out of your retirement plan, the interest that you paid on that loan will be post tax dollars.

Not the amount of the loan plus the interest – just the interest.

So the interest is not going to be eligible to be rolled over to say an IRA or some other retirement plan. So that money comes in a separate check, because you took loans. There are lots of situations where you and I both read this in the article where people go from the payoff one loan and they’ll start another one right away. Yeah.

This is a cash flow problem that really it should be addressed. But in 2023, a lot of stuff a lot of stuff slips through the cracks. I think there’s a lot of information there with 401k loans trying to avoid them if possible. If you have questions about your 401k loans feel free to reach out to us. Before you get into a situation hopefully.. or where you’re where you’re considering taking one out.

That’s a good place to stop for now – that’s all we have for episode 466 of the podcast. Thanks for listening

Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions and securities discussed in this podcast.