A little more than 1 year ago, I took a loan from my 401(k) plan. Today, I paid it off early. I will never borrow from my 401(k) again. Here are the lessons I learned and why I'll never go back.
What is a 401(k) Loan?
Quite simply, it is sneaking into your retirement account and taking money out of it way before you're supposed to. And, you avoid taxes and penalties if you call it loan and pay it back, with interest, to yourself.
Missed out on nice growth
Although I had a nice bump in cash flow when I received the loan proceeds (I used it to put extra money down on our home), I missed out on a fantastic up-tick in the market. A quick analysis shows I missed out on almost 28% growth while I was paying it back to myself at an interest rate of 4.25%. So, my total cost for taking the loan was over 32% of the original loan proceeds. Here is a snapshot of what the S&P did while my money sat and watched on the sidelines (make sure to look at the green percentage in the bottom right-hand corner; that plus the interest I paid myself is what I missed out on).
Exposed to more volatility risk with little or negative ROI
When it comes to investments, risk is a major consideration. The more risk you take, the more potential return you can achieve. Because of the interest rate I was paying, the timing and frequency of my repayments, and the general volatility of the stock market, I significantly increased the amount of risk to which I exposed my money. Yet I had very little chance of earning a commensurate return. Sure, if the market was down 28% I could pat myself on the back. But the amount of additional risk could have wiped out some, if not most of those savings. Over time, the best way to manage investments is to minimize risk while maximizing the return. Clearly my 401(k) experiment was just the opposite.
Double taxes on interest payments
The interest I paid during the last 1.5 years was with after-tax dollars. So I put already-taxed money into a plan that will require I pay tax on it again when I take it out during retirement. Let's imagine I paid a total of $500 in interest up until I paid the loan off today. Assuming a 25% federal and 5% state tax bracket when I withdraw money during retirement from my 401(k), totaling a 30% tax bracket, that means I have to pay an additional $150 on my already-taxed funds. All of the sudden my low interest rate doesn't look so low any more and results in more overall risk exposure and erosion of after-tax earnings.
Emergency if you leave the company
Here comes the trickiest and riskiest part. If, for any reason, I am no longer an employee of the company, I have to pay back the loan or I am subject to early withdrawal penalties of 10%, not to mention the entire unpaid loan amount would also be taxable. I caught a glimpse of what this might be like last year when the company I work for was purchased by another company. To get everything organized correctly, we were all fired by the old company and then immediately hired by the new company. We started on the new company's 401(k) plan immediately, but the old plan treated me like a terminated employee and was going to report my loan as taxable and subject to penalties. Luckily I worked out an arrangement with the new company to avoid this, but the risk of this happening is very real.
Laziness and lack of discipline allowed debt into my life
Along with my credit card use, this 401(k) loan was probably my most irresponsible financial decision. And it all came because I got lazy and lost my discipline, neglecting the principles I had adhered to my whole life.
Done and done. Never again. Retirement investments are just that...for retirement. Have discipline, don't be lazy, and stick to the values of abhorring debt. If you are in debt, annihilate it with every spare dollar you earn until it is gone. If you are out of it, don't go back. Ever.