401k Loans Are Bad?
Here are some key takeaways:
– Taking 401k loans can significantly impact retirement savings due to missed opportunity costs, potentially reducing the final balance by hundreds of thousands of dollars.
– Having an emergency fund is crucial to avoid dipping into retirement accounts for unexpected expenses.
– 9 out of 10 employees experience a significant spending spike of 25% or more over a 12-month period, highlighting the need for substantial emergency savings.
– The top three reasons for taking 401k loans are: paying off credit card debt, covering medical expenses, and covering other emergency expenses.
– Defaulting on a 401k loan can lead to taxable income and penalties if under age 59.5.
– As retirement approaches, it’s important to diversify savings beyond just a 401k, considering options like brokerage accounts or building cash reserves.
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401k Loans Are Bad? – Transcript
The one area that we’re going to drill down on today is 401k loans and what that can do over the course of someone’s career. We’re going to start out walking through and comparing two different scenarios. The first scenario is without the participant taking a 401k loan, so they work between ages 25 and 65.
Their starting salary is $30,000 a year, increasing 2.5% each year. It’s invested in a 60/40 mix of 60% stocks, 40% bonds. Without 401k loans and 5% salary contributions and a 5% employer match between ages 25 and 65, their ending balance is $1,324,500.
Now, take all of that same information, with a couple of differences. The first is a loan taken out at age 32 for $10,000, paid back over 4 years with a 7.5% interest rate. Contributions continue after the loan is paid back until age 50 when another $10,000 loan is taken out with the same parameters.
Contributions continue from 55 to 61 when a $10,000 withdrawal is taken out but not paid back. The ending balance is $937,100. That’s almost $400,000 less, but you’re only taking out two $10,000 401k loans and a $10,000 withdrawal.
When JP Morgan ran the math on this, they showed that when you take out 401k loans and pay back the interest, you do get some of that interest, but you miss the opportunity cost of not having that money invested in the market while you are taking the 401k loans out and paying it back.
You miss a lot.
One suggestion was to continue making contributions on top of paying back the loan, but that might mess up your day-to-day or month-to-month cash flow even more. Obviously, if you can keep the contributions going in, that’s going to leave you in a better position.
The numbers jumped off the page because it’s $30,000 that you took out, but the difference – almost $400,000 – is substantial.
The point is that 401k participants, people just starting their careers, or anyone really, need to be able to cover emergency expenses. They need to have that cushion of savings at the bank so they don’t have to dip into 401k loans, or another investment or retirement account.
It speaks to the importance of an emergency fund. It’s probably better to have more cash at the bank and less invested if it means you can stay the course with the investments. Staying the course means being comfortable during market downturns, which are inevitable and happen every year in varying forms, but also dealing with unexpected expenses.
You don’t want to be in a position to be a forced seller for either of those reasons – because you can’t stomach it or because you just need the money for something else. Maybe it seems counterintuitive to have less money or lower contributions going in, but you can always contribute on a recurring basis at a lower total and send in one-time contributions if we’re talking about a brokerage or an IRA or something like that.
Even with a 401k, you could reach the end of the year and work with payroll to “bulk up” your contributions when you know more about your cash flow and the unexpected things that happened over the course of the year. It does leave some of it to chance, but if you’re not automating, then maybe it doesn’t even happen.
You have to weigh the pros and cons, but I think you want to right-size it. The common themes we hear from people taking 401k loans are to fill a gap in their personal finances.
You’re not really solving the problem; you’re just transferring one loan for another.
It’s hard to get ahead when you’re scrambling all the time to finish off one loan and have to take out another loan to finish the other loan. It doesn’t really make sense.
Maybe something to consider is when you pay off the loan, not necessarily just going back to whatever the situation was (5% contributions to get the 5% employer match), maybe you do 2% contributions or something like that.
Or do no contributions at all for a couple of months after you’re done paying the loan. And then use that extra cash flow to build up the emergency savings account. I know it’s especially tempting after paying off a loan to just want to get back into it and restart your contributions, but you don’t want to be in another situation a couple of months or a year or two down the road and need to take another loan out.
To share a couple more numbers from JP Morgan’s study: 9 out of 10 employees experience a significant spending spike over a period of 12 months. They defined a spending spike as 25% more than their baseline spending over 12 months.
So if we make up an imaginary budget where expenses are $8000 a month ($96,000 a year), 90% of people experience a year where spending is 25% higher due to that unexpected spike.
With that budget, people will need to be able to absorb a $24,000 shock. That’s 25% of the annual budget. You need to have that in savings. You can bank on an unexpected cost popping up out of nowhere that you need to be prepared for and insulated against, pretty much annually at this point.
It’s something I’ve heard for decades now: people want to really try and “stick a landing” or fine-tune exactly how their money is invested and situated. There’s a lot of people that just don’t like the idea of money sitting at the bank, “not doing something.”
But if it’s there as your emergency fund or reserve, that serves an important purpose! And you need to have it.
You can’t draw that down to zero. You’ve just got to be prepared for the unexpected. The top three reasons for taking 401k loans, according to JP Morgan, are:
1\. pay off credit card debt
2\. cover medical expenses
3\. cover another emergency expense.
It’s interesting the percentage that represents a spike in this study is 25%.
Because I know that a common way we try to stress test retirement income plans is by taking their expenses and boosting them by 25%. It’s a good margin for error to bake into the plan. And even if it seems unlikely, these numbers would suggest it’s probably not all that unlikely.
If your income plan works well at the base level; and then breaks at 125%, then it speaks to the fragility of things. And that can probably guide you in terms of what you want to do moving forward. Or what kind of decisions you want to make with things like spending. Or how flexible you might need to be if we enter a poor market environment.
The big takeaways when we hear people talking about or considering taking 401k loans is that they’re not making ends meet, for whatever reason.
They’re basically trying to fix a hole or patch something. But they’re going to be borrowing money to do it. Yes, there’s always the argument that you’re going to be paying yourself back. But you miss out on that long-term compounding when you basically stop that by reversing course and taking money out of a retirement plan.
There’s also another risk, which they didn’t really get into. But in the second **(correction: third)** example where people took money out and they just never paid it back. If you take money out, in the structure of 401k loans and you don’t pay it back. Or you don’t make, I think, it’s two payments in most cases, that is considered a default. If you’re under the age of 59.5, not only is it taxable income, but you’re now going to have a penalty on top of it.
You’re just compounding one money mistake after another.
This could all be avoided if you had money outside the plan sitting in a reserve account.
For retirees too, it’s equally as important as someone who is in their working years, especially if your main bucket of income is a tax-deferred savings account like a 401k or an IRA.
If you need to take dollars, in this case, if the person’s retired, it would just be a distribution, not a loan. But every dollar you take out of there is going to be taxable income. You’re going to need to take out more than you planned on, so you can withhold the correct amount of tax. Whatever you need, you should just assume it’s whatever you need plus your marginal tax rates, and also at the state level, so it can compound pretty quickly.
On one hand, you probably don’t want to take money from a retirement account before you need to. But the idea of unplanned expenses being paid for by further retirement account distributions can get complicated from a tax perspective too. If you’re not adjusting the withholdings on the go, you could end up under-withheld there and have a tax issue, all the same as what we’re talking about with maybe unintended 401k loans turning into distributions.
It can get messy.
On a somewhat related note, how often do we see people getting close to retirement and have most of their assets are in a retirement plan? They don’t really have a whole lot of cash. What percentage would you say people are showing up with those kind of looks?
75, 80%? I think it’s more common than that.
It speaks to the nuance of investment planning and retirement planning. Because I think it’s pretty common knowledge for people to contribute as much as they can to their workplace plan and plow as much money into their plan. The earlier you start, the more time you give yourself for that money to compound, and that is true.
But you can also, especially as you’re approaching retirement, take a peek under the hood and see if it’s worth it to continue to contribute to a 401k or tax-deferred investment account. Or you can save in a regular brokerage account. Or you can just build up your cash cushion at the bank and then use that to live off of in the first year or two or 3 of retirement.
I think it’s just the 401k is the default, and so a lot of people are doing that. And I think it’s a good thing.
But sometimes it seems like the 401k, especially if you’re in a position where you’re hitting the max pretty comfortably or easily with your income towards the end of your career, it almost seems like if you’ve checked that box, then you’re not considering other ways to save that could help from a tax diversification standpoint.
So if you’re hitting your 401k max at 10 or 15% of your salary, you should be thinking of other ways throughout the year to supplement that with an additional savings plan into a different sort of tax bucket. Even if it’s just something like a brokerage account, or building a sufficient emergency reserve. Both would be ideal.
They give you some flexibility as you get to the distribution phase. But I guess you don’t want to discourage people from doing something like contributing to their 401k. It’s a definite positive and it’s better than doing nothing. But there may be more to do, and I think that sometimes gets lost in translation to folks or set aside.
Maybe that’s why we see so many reach the retirement phase of their lives with just a 401k and very little elsewhere.
It really does limit your options when you’re talking about managing taxes and retirement income distribution. It doesn’t have to be an on-off switch too. It can be a gradual taper. Or you can just lessen the amount that you’re contributing to a 401k. It doesn’t have to be black and white. It usually never is.
It’s interesting how we have conversations with folks in their 30s and 40s. And they want, or need, to take out 401k loans to rebalance the balance sheet.
As Casey alluded to a few minutes ago, sometimes we suggest, “Hey, maybe you downshift a little on how much you’re actually contributing to the plan,” or something really drastic.
And for the financial planners who are listening to this, just cover your ears, but maybe for a year or so you just suspend making contributions to the plan and put that money into a savings account.
Maybe that’s an answer. But also if you’re in such cash flow dire straits, we’ve got to look at whether there are any other ways to reduce. I can fully appreciate if somebody is truly in a position where their income is just not keeping up and everything that they’re spending money on is a necessity.
But when you’re in that situation, I think that’s like the easy answer, and it does solve the problem, and it should be part of the conversation.
It’s creative and probably not something that’s being thought of. But it’s definitely not the best solution. It may be the “cleanest (dirty) shirt in the dirty hamper” thing. In terms of, I guess, if you’ve exhausted all other options or ways that you could fix your cash flow. Then obviously, if that’s the only thing you can do, then sure, don’t contribute to your 401k and then just take the money right back out. That’s silly, right, but it’s drastic.
It also breaks up the habit. I think Brendan mentioned before, one of the main benefits of the 401k is it’s a default. You set it and forget it, you never even see that money. It just gets zapped automatically from your paycheck into the investment account. If you break that up, the chances of starting again are… It depends on the person, but I feel like they’re definitely less likely to restart.
It’s a lot harder to go back.
So you want to keep the momentum up if you can. But you have to explore every option. And everything’s got to be thrown on the table.
Emergency fund, it’s one of the basics! But there’s a lot of thought that should be put into it.
