401k Loan Question

[isaac]

Before you jump down my throat - No I'm not considering a 401k loan. I just have a question.

It seems like most of the people I work with use 401k loans pretty regularly. I try to tell them it's a bad idea but they argue the interest rate is lower than any other option and they're paying themselves back the interest. They almost sound as if they believe they'd be stupid for NOT using 401k loans regularly.

I can't make an argument in the conversation if I don't understand why it's such a terrible idea. Our 401k website has a "401k loan impact calculator". I model a loan for $5,000 for 12 months at 4.25% interest, with 20 years left until retirement and an assumed rate of return of 8%, it tells me I'm losing $809 in interest, assuming the market does return a steady 8%. Steady 8% seems VERY optimistic to me.

Is $809 more than a standard unsecured personal loan??

Had a guy tell me just the other day that a "401k loan is only bad when the market is doing well" I guess he thinks he's saving money by having his 401k liquid at the moment since the market is not looking well. I think the problem is my employer's website makes it VERY easy to just log in and request / have the money in your bank in minutes.

[MonkeyMama]

As with most things debt, the downside is not simply the interest.

The bigger downside is that in most cases if you lose your job the loan becomes due. The vast majority of people can not pay off these loans when they change jobs or lose their jobs. In that case it turns into a distribution that is taxed and penalized. (I've had a few clients have 401k loans turn into distributions because even though they swore they would have paid off the loans if they knew, they didn't know and it was just a big surprise at tax time. These were cases where they voluntarily changed jobs and just didn't understand anything about their 401k loans).

[isaac]

As with most things debt, the downside is not simply the interest.

The bigger downside is that in most cases if you lose your job the loan becomes due. The vast majority of people can not pay off these loans when they change jobs or lose their jobs. In that case it turns into a distribution that is taxed and penalized. (I've had a few clients have 401k loans turn into distributions because even though they swore they would have paid off the loans if they knew, they didn't know and it was just a big surprise at tax time. These were cases where they voluntarily changed jobs and just didn't understand anything about their 401k loans).

We live in very rural area of West Virginia. We work at an auto manufacturing plant. It's WAY above the local average wages, but still comprised mostly of high school educated workers. Changing jobs is really not an option around here. Where would we go, the Dollar Store? As far as job security, Toyota claims to be the only manufacturer that did not lay-off any North American employees during the last recession.

The mindset around here is strongly "you can't take it with you when you go" "never seen a herse with a trailer hitch" You know, like all of the country music songs say. I know I can't get through to them in an argument but I'd still like to understand why a 401k loan is considered fiscal insanity.

[Drake3287]

I think you answered your own question. No one has higher education past high school and I bet many of them don't even have that. Pretty simple. Your question is a lot like people that take out a HELOC and use it to live off or buy toys and vacations with. Very dangerous way to live and most of these people will never be financially secure.

I, and most of us here have friends that live like this and it's crazy. All of my co-workers make well over $100,000 a year and many of them with spouses make close to $200,000 but you'd be surprised at how little money they have saved. They have nice car's and trucks and pay monthly rent that's double of my mortgage payment.

[disneysteve]

What is wrong with taking 401k loans? Let me give a few answers.

1. 401k plans are RETIREMENT savings. The money in them shouldn't be used for anything but RETIREMENT except for some catastrophic emergency - to save a life basically.
2. 401k loans become due immediately if you leave your job.
3. The money in your 401k was contributed pre-tax but 401k loans get repaid with post-tax money. That means that in retirement, those funds will be taxed a second time. By taking and repaying a loan, you are voluntarily paying taxes twice on that money - not too bright if you ask me.
4. One thing that you can never replace in your investing life is time. When you take money out, you lose the compounding on that money. You never get that back so a relatively small loan can cost you tens of thousands over your working life.
5. The biggest problem is that anyone taking a 401k loan is likely doing it to fund a lifestyle that they really can't afford. Why are you coworkers taking these loans? New cars, vacations, home renovations, etc. most likely. Either that or they are in debt and behind on their bills due to overspending. The simple fact that they need to consider a 401k loan is a huge red flag.

The fact that they contribute to a 401k at least shows that on some basic level, they understand the value of saving for the future. The fact that they turn around and pull that money out later, however, defeats the purpose of that saving.

[bdoubleu]

3. The money in your 401k was contributed pre-tax but 401k loans get repaid with post-tax money. That means that in retirement, those funds will be taxed a second time. By taking and repaying a loan, you are voluntarily paying taxes twice on that money - not too bright if you ask me.

This. I feel like this is rarely addressed, and I feel like it is the biggest problem with 401k loans (aside from losing/quitting the job and having to pay it back or pay taxes on it as a distribution). Everyone hates taxes, but DOUBLE tax on this?!? And nobody that uses 401k loans bats an eye!!