401(k) Loans Are Not An Investment
Should I Borrow Against My 401(k) to Get Bond-like Returns in it?
Q. We took maximum loans against our individual 401(k)s because we knew our jobs were VERY stable. We charge ourselves the maximum interest, paying the loan back with after-tax money obviously. Since the interest rate is more than current bond yields, we feel this would be a good investment. I might miss bigger returns by not investing in equity market, but I have a higher yield than the bond market, and feel like I am exposed to less volatility risk. What do you think?
The Return is 0%. That Is NOT Bond-like.
A. You’re not the first to think of this. Given the interest rates on 401(k) loans are Prime (currently 5.25%) + 1-2%, a guaranteed return of 6-8% on 401(k) money can seem pretty attractive. However, what you must realize is that the return on investment here is not 6%, it’s 0%. The reason why is that you’re paying the interest yourself. You pay 6% to yourself. So you pay 6% and you receive 6%. There’s no extra 6% there. 6% – 6% = 0%. You had the same amount of money you had before. Let me explain.
- Imagine you had $10,000 in your 401(k) and $600 in a taxable account, for $10,600 total.
- Now you borrow $10,000 out of your 401(k). You now have $0 in your 401(k) and $10,600 in your taxable account, for $10,600 total.
- A year later, you pay the $10,000 back to your 401(k) along with the $600 in interest. Now there is $10,600 in your 401(k) and $0 in your taxable account, for $10,600 total.
Where’s the investment return? That’s right. There isn’t any. Don’t believe me because I’m just a doc? Would you believe Michael Kitces?
Technically it does allow you to put more money into your 401(k), since all of the interest paid does actually go into the 401(k). However, it’s even worse than a non-deductible IRA. Not only do you not get a deduction for that interest paid into the 401(k), but it doesn’t even increase the basis of the 401(k). You put after-tax money in, but when you take it out you have to pay taxes on it! That’s a lousy deal. Essentially, that money paid as interest would be taxed twice.
Besides, even if this were a good deal, it would be a pretty limited one. You can only borrow out half of your 401(k), up to a total of $50K. So assuming only one 401(k) for you and one for a spouse, this would only work for $100K of your portfolio. That’s a significant chunk of a $500K portfolio, but not of a $5M one.
401(k) Loans Are Not Double-Taxed
Please note, however, that 401(k) loan PRINCIPAL is not double-taxed, only the interest paid on that loan is taxed twice (once when you earned it at your job and again when it is withdrawn from the 401(k). This has been well-explained here, here, and here. Note that if you borrow from the Roth side of the 401(k), that double taxation doesn’t occur, making the “deal” slightly better (although the return is still 0% and you’ve now lost the opportunity cost on a larger amount of after-tax money to get the same size loan.)
401(k) Loans Not As Bad As They Used To Be, But Still Bad
401(k) loans used to be really bad. If you had an outstanding loan and were fired or left the job, you had to have it paid back within 60 days or it would not only become taxable income to you, but there would be a 10% penalty due to the IRS. Thanks to the tax law changes made at the start of 2018, you now have until your tax return is due (including extensions) to pay the loan back without penalty. So if you took out a loan on January 15th of 2019 and then quit your job, you could have up to 21 months to pay it back. That’s good, since about 10% of 401(k) loans were never paid back prior to the law change.
So if paying prime + 1% to your 401(k) provides a much lower interest rate than any other option you have, a 401(k) loan might still make some sense. However, a rule of finance is that those who receive interest generally come out ahead of those who pay it. That fact doesn’t change just because you’re borrowing your own money. There is a cost there and it’s the same cost whether you spend cash you have, spend a bank’s money, or spend money borrowed out of your 401(k). It’s opportunity cost. Money used to consume can’t be invested at the same time. (Technically there is an exception to that, but the downsides of that technique often outweigh the upsides.)
Those who receive interest generally come out ahead of those who pay it. That fact doesn’t change just because you’re borrowing your own money. There is a cost there and it’s the same cost whether you spend cash you have, spend a bank’s money, or spend money borrowed out of your 401(k).
One Good Reason For a 401(k) Loan
I can think of one good reason to take out a 401(k) loan. If your 401(k) sucks and you can’t get your employer to improve it, you can still contribute to the 401(k), then borrow the money (up to 50% of balance or $50K, whichever is less) out of it and invest it elsewhere. If your only choices are crummy 3% ER loaded actively managed mutual funds, that could be a good idea. Note that the 401(k) has to be REALLY terrible for you to come out ahead, since you’re basically now investing that money in a taxable account where tax drag (from capital gains distributions, dividends, and interest) occurs. If your 401(k) is really that bad, you might be better off leaving articles like this one around the office anonymously.
The bottom line is that there is no free lunch with a 401(k) loan, so don’t kid yourself that you’ve discovered one. If you have to borrow money, it’s not the worst way to borrow it, but I wouldn’t make a habit out of it.
What do you think? Have you used a 401(k) loan? Why or why not? Comment below!