Didn’t you know? The 401(k) loan is broken. On one hand, it’s a cheap way to borrow, the rate is currently about 4%, a great way to put more return into your retirement account, as other risk free rates are far lower, but with these benefits comes great risk, the risk that if you lose your job, you have a short amount of time to replace the money or pay both a 10% penalty and tax at your marginal rate. To make matters worse, even if you change jobs, it’s quite the trick to transfer the 401(k) from the old job to the new one and take the new loan out in time to pay the old. I’ve heard of people doing it, but it’s not as easy as it should be.
I don’t view routine borrowing as something to encourage. However, as part of the big picture prudent borrowing can help jump start one’s savings. For example, a $60K earner with a newborn finds that the budget is pretty tight, and being risk averse decides his emergency funds are too low. As the wife isn’t working and may not return for a year, he decides to stop his retirement contributions. Since the first 5% of his income would have been matched, this decision to not deposit this $3000 results in a loss of $6000 for his retirement. With different loan rules, he might view the loan risk a bit differently, and keep up the deposits, knowing he’s able to borrow the half he deposited.
When it comes to the 401(k) loan, there is nothing stopping congress from passing new rules. “If separated from the employer, the plan participant’s loan payments are suspended for as long as the unemployment lasts. When employed at a new company, the remaining balance is directly transferred along with the fact that there is a loan in place with the same terms and remaining balance as the original loan.” Congress, are you listening? What if the worker doesn’t regain employment? I’d suggest it’s bad enough to have someone out of the workforce, do we really want to chase them for the tax due on their loan?
I did one calculation, $10,000 owed to a credit card at 18% paid over 5 years will cost $254/mo. The same $10,000 taken as a 401(k) loan would be paid in 42 months using the same payment. 3-1/2 years instead of 5. And during that time, 4% going into the account instead of the sub 1% a short term government bond fund will return. In the big picture this may seem a small issue, but it’s one way those without the ability to borrow at low rates are getting the short end of the stick. On one hand, these loan are available and can be used to one’s advantage, but the flip side is the risk is too high for many. This small change can fix the 401(k) loan.