≡ Menu

Fixing the 401(k) loan

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.

 

{ 4 comments… add one }
  • JOE February 10, 2012, 10:20 pm

    I understand perfectly, we just disagree, which is fine. Do you really believe the guy that has a $40K loan outstanding and is out of work for say 4 months, deserves to be hit with a $16K tax bill? 25% plus a 10% penalty? I understand if you’d tweak my proposal with an age limit, so a 60 yr old can’t take a loan and then retire, for example.

    I maintain that the current loan provisions discourage the proper use of a loan for those who need it and can benefit from it the most.

  • NB February 10, 2012, 10:04 pm

    Joe, you need to understand all the facts before you write. The reason the loan becomes taxable to you when you leave your job is because the money you borrowed was NOT TAXED when it went into your 401(k). So if you’re not working, and you’re not going to pay it back in a reasonable length of time, then you owe tax on it. Sorry. Otherwise, us taxpayers who do not take loans from our 401(k) accounts would be giving you deadbeats a free ride from our tax dollars. Not fair.

  • Jon S February 14, 2012, 12:33 am

    Joe – great post! Long wondered why this hasnt been addressed. Found your post doing a search for “401k loan broken”.

    Great minds think alike, no?

  • JOE February 14, 2012, 6:58 am

    Ha! Very Cool, Jon. Glad you like the idea. Thanks for commenting.

Leave a Comment