 Shakespeare in Debt
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By Scott
Lummer
Chief Investment Officer, mPower
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This week's question is a common one — about robbing
Peter to pay Paul.
The interest rate to borrow on my 401(k) plan is
relatively low. Shouldn't I borrow from the plan instead of other sources? If I do, what
are the tax implications?
Shakespeare's Hamlet said: "Neither a borrower
nor a lender be." (I wrote this so you would think I was culturally refined and
attended a lot of Shakespearean performances — otherwise know as "algebra on
stage." Actually, I heard the line on a "Gilligan's Island" rerun).
Well, the Bard would be doubly upset when you borrow from a
401(k) plan, because you are both the lender and the borrower. When you take a loan from
your plan, you get the money and pay interest just like a regular loan. However, an
account is set up within your plan that reflects the amount of the loan, and you receive
the interest that is paid on the loan. Hence, you are also the lender. In essence, you are
simply borrowing from yourself.
I don't like to see people borrowing from their retirement
plan for three reasons (like baseball strikes and bad omens, my justification typically
comes in threes).
Debt and Taxes
First, borrowing from yourself is a bad tax deal for most
people. Let's presume that you have some money in a bond fund in your 401(k) plan that is
earning 6.5 percent. Let's say you can either borrow from your 401(k) plan at 6.5 percent
(the actual interest rate doesn't matter because you are borrowing from yourself), cashing
in the bond fund to pay for the loan, or you borrow in a tax-deductible way such as a home
mortgage at 8 percent. Regardless of how you borrow, you have an account earning 6.5
percent (either the bond fund or the loan account). At first glance it looks like
borrowing from the plan is a better deal, saving 1ý percent of interest. However, the
retirement plan debt is not tax deductible, while the home mortgage is. If you are in a 28
percent tax bracket, the after-tax cost of the loan is only 5.8 percent. If your tax rate
is higher or you pay state taxes, the mortgage is even a better deal.
The Land of Lost Opportunity
One thing that people who borrow from their plan forget
about is the lost opportunity for growth. When you borrow from your plan, the total net
amount invested in your plan is reduced by the amount of the loan. Yes, you will
eventually pay back the principal, but you lose the rate of growth. Let's look at two
investors, Claudius and Polonius, who each had $100,000 invested in stock funds in their
retirement plan in January of 1995.
Claudius borrowed $50,000 from his plan, while Polonius
didn't. Assuming they never invested another penny, by December 1999 Claudius would have
$247,000 in his plan, while Polonius would have $357,000 — a 45 percent difference!
The reason is that the market did very well over the past five years, making the effective
cost of Claudius' loan 29 percent. Now, I wouldn't expect the market to earn such a high
return in the future, but I still would expect the average 401(k) plan to earn a return
higher than the 401(k) loan rate.
Don't Bite Your Nails
As you may remember you mother telling you, bad habits are
hard to break. Philosophically speaking, borrowing from your 401(k) plan is a bad habit.
The whole idea of a retirement plan is making some sacrifices in the near term so you have
some long-term security when you are finished working. By borrowing from the plan, you are
sacrificing returns over a long-term period to get some money for short-term spending. It
completely defeats the purpose of why you are investing to begin with. It's kind of like
those squirrels who spend months storing away nuts for the winter going on an October
binge and throwing a roasting party. Doesn't make a lot of sense.
What about Exceptions?
Of course, there can be emergencies when you can't borrow
money from any other source. If you need the money, you need the money, and no economic
analysis will dissuade you from raiding your nest egg. Indeed, I have a friend who is an
Internet entrepreneur who raised $200,000 of his start-up capital by borrowing from his
401(k) plan. He is now worth over $200 million. But, my friend is an extreme exception
— most people do themselves a disservice by borrowing from their plan.
So borrow from the bank, borrow from the money store, even
borrow from that guy Bruno down on the street corner. Just keep your hands off of your
401(k) money. And, don't fall in love with family rivals from Verona.
 Lummer's Logic Archives
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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