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A 401k loan is such a bad investment choice that it should not be allowed in any plan other than for hardships. And yes, it is an investment because when plan participants take a 401k loan, it becomes one of the investments in their account. Consider that:
Borrowers often lose the company match
Many participants who borrow from their 401k accounts end up stopping or lowering their 401k contributions while paying back the loan. This often results in the loss of 401k matching contributions when a participant’s contribution rate falls below the maximum matched percentage.
Job changes can force defaults
Most participants considering a job change don’t realize that their outstanding 401k loan balance becomes due when they leave their current employer.
In the case of involuntary job loss, an outstanding 401k loan can add significant pain to an already difficult situation. Regardless of whether a job change is voluntary or involuntary, nearly all participants don’t have the financial resources available to pay back their 401k loans when they separate from service.
As a result, a large percentage of these participants are forced to default. The defaulted balance is then subject to state and federal taxes, and possibly state and federal early withdrawal penalty taxes. Plan balances that leave a 401k plan forever (before retirement) are referred to as leaks. Leakage from defaulted 401k loans makes it less likely that participants will build adequate retirement savings.
Opportunity costs can be substantial
Assume that a participant takes a $10,000 loan for five years at 6 percent. The investment experience on that portion of the participant’s balance will be a 6 percent return for five years. Had the loan balance been invested in the investment options in the plan for the same period, the participant may have earned a lot more. For example, the five-year return on the Vanguard 500 Index Fund through March 31, 2017, was more than 13 percent.
Interest on a 401k loan is not tax-deductible
Anyone who needs a loan should investigate the possibility of taking a home equity loan first since interest on these loans is tax-deductible.
Paying interest to yourself is not such a good idea
I have heard many participants say that they believe loans make sense because they are paying interest to themselves. They often add that the higher the interest rate, the better.
First, it is normally not a desirable financial strategy to pay interest of any kind. Second, why would you want to pay a higher interest rate on a loan just because you are paying interest to yourself? That just means you have less of a paycheck on which to live.
Finally, it appears that the interest on 401k loans is double taxed. Since loan payments are made on an after-tax basis, interest on each payroll loan payment is first taxed then and taxed for a second time when paid out as a distribution at retirement.
It’s the lender of last resort
Unless the plan uses hardship provisions to qualify for a loan, a plan sponsor cannot deny a participant loan request. This makes the 401k plan the lender of last resort and results in many bad loans being made to participants who are not creditworthy. Easy access to 401k loans can often make a participant’s bad financial situation worse.
Many participants have asked, “If taking a 401k loan is so bad, why would the company let me do it?” Good question. It’s clear that participant loans can drastically reduce an employee’s chances of achieving retirement readiness. As a result, plan sponsors should seriously consider limiting loan availability to hardship criteria or eliminating loans entirely from their plans.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC.