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Why 401(k) loans are bad

Nov 12, 2015 10:17:03 AM
Author: Scott Hanson

Listen to Scott and Pat discuss why taking a loan from your 401(k) is a bad idea and can have a negative effect on your retirement savings.



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Scott Hanson: 401(K)s. The majority of companies allow their employees to borrow against their 401(K)s. It turns out that 26% of people, roughly one of four individuals, with a 401(K), has an outstanding loan on it.

Pat McClain: Really?

Scott Hanson: Yes.

Pat McClain: Twenty-six percent?

Scott Hanson: Yes. The 401(K)s...

Pat McClain: I should know this.

Scott Hanson: Well, not really. You don't usually know this because you are not an advocate of 401(K) loans.

Pat McClain: No.

Scott Hanson: You say that they are not healthy for you financially.

Pat McClain: For most people, they are not.

Scott Hanson: And here's the problem. Here's why we don't like 401(K)s. First of all, 401(K) loans. You can take a loan, you can borrow half your account balance to a maximum of $50,000. That rule hasn't changed since I entered the business 25 years ago, whatever. $50,000 is the maximum you can borrow, it's up to 50% of your account balance.

Now, the challenge with these loans, so somebody will say, "Oh, they're good because the interest you're paying is going back into your own accounts, so you're paying yourself." The problem is a couple things. First of all, when you're taking a loan, you're missing out on an opportunity for your own dollars to be there working for you. So when you take a loan, let's say your account balance is $25,000...

Pat McClain: And you borrow $12,000 out...

Scott Hanson: You only have $13,000 working for you. It's not like a margin loan would work on a security or a real estate loan would work on a home. In a real estate loan on a home, the home value's still there, all the home's there.

Pat McClain: In a 401(K) they liquidate that position and give you the money.

Scott Hanson: Correct. So you're missing out on that opportunity. So that interest you think you're paying to yourself, well, you would've been earning interest anyway that you no longer earn.

Pat McClain: If you separate from employment...

Scott Hanson: This is the biggie here.

Pat McClain: ...it becomes a taxable event to you with all taxes and penalties due.

Scott Hanson: Yeah. So you're at your job, you get a job offer across town, better job. You think, "Oh, I'm going to do that." If you can't pay your loan back...

Pat McClain: Is it 30 days or 60 days?

Scott Hanson: It depends. There's some companies up to, every company is different. I've seen up to a year but the loan needs to be repaid. If you can't repay the loan, it becomes due and taxable to you with penalties. You lose your job. Your company goes through downsizing. Not only are you now out of work...

Pat McClain: You've got a tax bill.

Scott Hanson: A 401(K) loan you can't pay back. You've got a tax bill.

Pat McClain: And most people never pay them back if they separate from employment. Which is why they took the loan in the first place is they didn't have the money.

Scott Hanson: So anyway, we're not big fans of 401(K) loans. Last resort...

Pat McClain: I had no idea it was 26%.

Scott Hanson: One out of four.