Should I Borrow From My 401K?

Many Americans may find themselves asking this question in today’s economy. The Great Recession and its historically high level of unemployment have left many with few other options. In the past, people could refinance their mortgage or take out a home equity loan but the collapse of the housing market has left many underwater. So it may seem like a last resort, but is a 401k loan a good idea?

Photo by {Guerrilla Futures | Jason Tester}

A BankRate reader recently asked Don Taylor just this question. Here’s the gist of don’s reply.

Don points out that it’s notoriously difficult to “run the numbers” to compare the cost of a 401k loan vs. other debt (ex: will you save money borrowing from your 401k to pay down your car loan) because it’s impossible to know for sure what the 401k loan will really cost you in the end. It’s easy to compare interest rates, and the financing cost of the loan, but you can never truly account for the lost compounding effect from having that money continuously invested (and any dividends re-invested). In short, you can’t know for sure what the cost of having that money side on the sidelines is going to be.

Still, there are some situations where it can be less of an impact, if not an actual benefit to borrow from your 401k.

Here’s a list of when it might be beneficial to borrow from your 401k:

1. If you would need to borrow the money anyway from another source, if not your 401k.
2. If the after-tax interest rate on that other loan would exceed the “reasonable return” you can expect from your 401k over the term of the loan.
3. If you can make your 401k loan payment without reducing current 401k contributions.
4. If you accept the terms that you will need to repay any outstanding portion of the loan within 90 days of leaving your job or pay income tax on that balance along with a 10% penalty.
5. If the borrowed money is going toward repayment of a loan with no tax deduction (i.e. credit card debt).
6. If you get your financial ship in order to avoid the need to borrow so much in the future.

I added those last two points because I feel they’re important. I also don’t think it’s ever really a good idea to borrow from your future like this unless your present way of life is really in danger of ending. In other words, you have exhausted all other avenues and bankruptcy is not a way out.

I’ve had friends who have borrowed from their 401ks and never been able to pay them back because they never got their spending habits under control. This only serves to set them back financially in a big way.

In my own experience, when I’ve had to come up with some extra money to pay off debts, I’ve stopped contributing to my 401k and diverted that money toward the debt as extra payments. It’s painful at the time, but less painful than borrowing from my 401k, which only shifts the debt around and ends up costing much more in the long run.

It’s important to note that Don bases these points off of a paper by members of the Federal Reserve Board titled “New Evidence on 401(k) Borrowing and Household Balance Sheets.” This paper is also referenced by the Wall Street Journal article, “Rethinking Conventional Wisdom About 401(k) Loans.”

UPDATE: Thanks to NerdWallet for featuring this post it its Carnival of Money Stories – Oktoberfest Edition, and Personal Dividends for featuring this post in their Carnival of Wealth #4 – The Family Finances Edition.

Related Posts:

• Dumb Money Tip from SmartMoney Mag.
• 70 Year Old Free Spirit Offers Lessons on Retirement Planning.
• Are Retiring Boomers “The 401(k) generation”?
• How to Save for Retirement When Your 401(k) Plan Sucks.
• Generation Y slacking on Savings?

Investing For Beginners – Active Vs Passive Funds.

A few weeks ago, I responded to a reader’s question about How To Start Saving For Retirement At 40. In that post, I made mention that you can’t really save for retirement – you must invest for retirement. I also said that it’s beneficial to have an understanding of the basics of investing, even if you leave your retirement planning to your 401k plan administrator.

One of the basic concepts of investing is the idea of active funds and passive funds.

I’ve just come across this post about active vs passive funds by Craig Ford at Christian PF.com that does a good job of breaking down the differences between active vs passive funds and which is better.

As I say, even if your interest and involvement in retirement planning doesn’t go beyond your company 401k plan you should at least know the general idea beyond these funds, so check it out!

Related Posts:

• Are Retiring Boomers “The 401(k) generation”?
• 2009, year in review.
• 5 Reasons To Avoid Index Funds?
• How NOT to fix the 401(k).
• Are You on Track to Retire Comfortably?

2009, year in review.

What a year it’s been!

As the history books close on 2009, I thought it might be nice to take a look back on the topics that were hot on Simple Debt-Free Finance over the past year.

401(k) Plans.

2009 saw a lot of talk about the future of the 401(k). It seems only natural, given that it is one of the major means of saving for retirement for many American workers who had just seen those savings drop like a stone in the 2008 stock market crash. A lot of the talk was centered around ways to “fix” the 401(k) when it isn’t broken. This bothered me enough to blog about it in that post as well as Fixing What Isn’t Broken and Why 401K Retirement Plans Really Don’t Work And How To Fix Them

Many workers, like myself, saw their company contributions to 401(k) plans cut or “temporarily” suspended. My response to that was to give my 401(k) some TLC, a move which paid off when my balance returned to pre-crash levels in the 3rd quarter of 2009.

Bank Failures.

Another hot topic of the beginning of the year was bank failures. So many failures naturally led many to wonder what the FDIC insurance limits cover.

Investing.

2008 was a big year for gold, and 2009 was even bigger. Such a bullish environment for gold led Rosland Capital to offer Gold Eagle coins for IRA accounts.

The 2008 crash created an historic opportunity for investors to “buy low”, but it also offered many reminders of what not to do. To that end, I shared Jim Cramer’s 10 commandments of stock trading.

Since the crash created a great opportunity for new investors to get into stocks at levels unseen in a decade, I put together a list of 10 investment tips for beginners:

1 Follow The Rules
2 Be Aware Of Taxes
3 Don’t Confuse Investing With Trading
4 Tune Out The Media
5 Don’t Tune Out Too Much
6 Pay Attention To Risk
7 Don’t Avoid Reality
8 Don’t Fall For Hot Stock Tips
9 Don’t Try To Time The Market
10 Try Before You Buy

In other news, some investing sites seemed to want to attack index fund investing in all the wrong ways. I had to respond to their criticism of index fund investing.

Credit Cards.

Kiplinger was nice enough to provide a 1st phase of credit card consumer protection rules went into effect.

I had a couple of posts about 0% balance transfer offers, mostly because 0% balance transfer offers were coming to an end at the same time my wife received a 0.99% balance transfer offer.

Since it seemed to be a hot topic, for me anyway, I decided to share 6 things you should know about 0% APR credit card offers.

And all this at a time when Bank of America began imposing fees for paying off your balance… idiots!

Government Bailouts.

2009 is likely to be remembered best for the bailout craze that gripped the auto sector, bank sector, heck – the entire nation!

credit card consumers got a bailout, the NASDAQ released a “government relief index” for tracking bailed out companies and cash for clunkers gave charities some competition

Debt.

What would a debt blog be without posts about, well, debt?

The year started out with discussions about toxic debt and ended with the mortgage debt relief program going until 2012.

In between was some discussion of whether debt settlement is a good idea, and why debt consolidation is (sometimes) a scam. When it’s not a scam, debt settlement and loan consolidation just doesn’t work, and you’re much better off taking a DIY approach to debt consolidation.

And just to round out the debt consolidation talk, I shared how it affects your credit score.

I asked, “Why are you in debt?”, but not too many people answered, so I got the top 10 causes for debt from BankRate.com.

Related Posts:

• First Premier Bank Credit Card Offer Features A 79.9% APR, a Bad Deal – For The Bank!
• Heads Up – Your Credit Score May Suffer Even If You Pay Off Your Card Every Month!
• Investing For Beginners – Active Vs Passive Funds.
• Using Secured Credit Cards To Rebuild Credit.
• Avoid These 5 Credit Card Rookie Mistakes!

Why 401(k) Retirement Plans Really Don’t Work, and How to Fix Them

I originally wrote this article back in January for the Saving Advice Blog, but I’ve seen a lot of chatter recently about it again – including this issue of Time magazine – and I feel very strongly about protecting individual retirement savings from the government, so I thought I’d go on the record here and post my thoughts about it on Simple Debt-Free Finance.

And now, without further ado, the article.

With the death of defined pension plans, 401(k) retirement plans have become a staple for many employees, but the recent financial turmoil has put these once infallible savings vehicles under the microscope. There have been numerous news articles detailing the stunning losses of the stock market since October of last year. Such stories usually offer a profile of some victim around 55 years old who was preparing to retire in the next few years, only to have 25% or more of his 401(k)’s value wiped out over night.

This has led to calls for the government to step in and fix the problem. Economist Teresa Ghilarducci has put forth a plan to do just that, and congressmen George Miller and Jim McDermott support it. Under Ghilarducci’s plan, contributions to a worker’s 401(k) plan would no longer be tax deferred. This would effectively tax the contributions twice – once when you earn the income that you then contribute to the plan, and again when you withdrawal the money in retirement. Under such conditions, why would anyone continue contributing to a 401(k)?

Ghilarducci’s plan also proposes implementing a government provided “guaranteed retirement account” to be administered by the Social Security Administration. Under this plan, worker’s would be required to invest 5% of their pay, and would receive a guaranteed return of 3%, adjusted for inflation.

This is the wrong way to fix the problem.

First of all, why would we want to reinvent social security when it’s been documented to be unsustainable? The government has already tapped the money many times over that was supposed to be set aside for the program. Isn’t this just recreating that problem? Secondly, the stock market has returned, on average, roughly 10% per year since WWII. How would worker’s be better off earning 3% per year? Thirdly, it doesn’t address the real reason 401(k) plans have left people short on their retirement funds.

The 401(k) plan did not fail. The stock market did not fail. This person simply had too much invested in the stock market for his age and retirement goal. The problem lies with the individual, and the lack of information and education provided to the individual, not with the 401(k) plan itself.

401(k) participants are investors, whether they know it or not. The problem is that most do not. The real reason 401(k) plans fail to the extent that people perceive them to is because the participant often lacks the education to make appropriate decisions. Many 401(k) participants don’t want to be investors, they just want to do their job and live their life. Another problem with 401(k) plans is that the individual is often entirely in charge of their investments, and have no safety valve in times of extreme panic or greed. Just look at the recent economic turmoil and see how many have pulled everything out of their 401(k) because they don’t trust the market. Once the loss has happened, pulling out is the worst thing they can do, but these people are simply reacting emotionally. They don’t have the background to approach it rationally.

The real way to fix this problem is education. Employers could provide professional assistance by way of making an impartial financial planner available to employees in the plan. Most plans provide life cycle or target date funds where employees choose the fund with their target retirement date, and the plan manager gradually adjusts the allocations between stocks and bonds over time. This is essentially a set it and forget it approach that has been proven to work over time. But so many employees are ignorant to their existence and their use. If that 55 year soon-to-be retiree had a proper asset allocation in his 401(k), he would still be on course to retire, though he might still choose to work a little longer for a better post-retirement lifestyle but the choice wouldn’t be so drastic as losing a quarter of your retirement.

Related Posts:

• Are Retiring Boomers “The 401(k) generation”?
• How to Save for Retirement When Your 401(k) Plan Sucks.
• Generation Y slacking on Savings?
• Should I Borrow From My 401K?
• Investing For Beginners – Active Vs Passive Funds.