Whether you’re facing home repair expenses from Hurricane Harvey, college tuition costs, or another immediate financial need, it’s pertinent to gather the funding from a suitable source to avoid major tax and investment return ramifications.
We often encounter clients who consider their 401(k) to be the first resort when they need extra cash. However, we consider this perception to be misguided, especially if an individual has access to home equity at a reasonable rate. In addition, such an assumption can lead to costly mistakes if your unique financial situation is not taken into account. In this article, I’m going to tell you why this misconception is so prominent and what you should consider before borrowing from your 401(k).
Of course, before you take out any debt, ask yourself if the expense you’re funding is sensible. Would you be better off delaying, or avoiding the expense entirely? It’s important to live within one’s means, and even if you hold home equity or vested balance funds in your 401(k), you should avoid borrowing from this source. However, we understand that life is full of surprises, and situations do arise in which a 401(k) loan may be the best, or only choice.
The “Pros” of 401(k) Loans: What You Don’t Know Can Cost You
People often perceive 401(k) loans as a first-choice option when borrowing a large sum of money. This is due to its generally low interest rates, and the fact that a credit check or an underwriting are not required for an individual to qualify. The Treasury Regulation 1.72(p)-1 requires that 401(k)s charge “commercially reasonable” rates on any loan. Most employers interpret this as the Prime Rate plus one or two percent. Therefore, with today’s low rates, 401(k) loans are available at five to six percent interest.
The second reason people choose to take out 401(k) loans is because they are borrowing money from themselves. They believe they can pay themselves back and get a “guaranteed” five to six percent on their 401(k) money without incurring significant loss. This is especially attractive when they do not see themselves likely to achieve over five to six percent with the current market.
On the contrary, I have seen clients shy away from refinancing their mortgage with a cash out, or tapping home equity with HELOC (Home Equity Line of Credit) loans. I’m not entirely sure why this is, but I believe that many people have a goal of eventually paying off their real estate debt, and retiring debt free.
The Cons of 401(k) Loans: Tricky Taxes
Let’s consider the following example to further explore the long-term ramifications of borrowing from one’s 401(k). William has $50,000 in his 401(k) plan that he would like to take out to assist in funding his daughter’s medical school costs. He is a conservative investor and has the $50,000 in a bond fund within his 401(k), which generates a 3% return.
William decides to use money from his 401(k) to fund the expense because, according to his beliefs, he will get the most for his money via this method. He will repay himself at a 5% rate, which William believes will result in an overall higher net return over time. William is partially correct. By essentially borrowing from himself, he will generate a higher return in his 401(k) than he had before. However, he did not consider the long-term cost of the 2% increase. William must front the 5% from cash flow to pay it back. In addition, the interest he’s paying to himself is not tax-deductible (unlike home equity financing).
Most importantly, once the interest is paid into the 401(k), it becomes pre-tax tax money. Thus, when William reaches retirement and withdraws the interest from his 401(k), once again, it will be subject to tax penalties. Essentially, the interest payment is a contribution to his 401(k) with after-tax money that does not retain any of its after-tax properties. Instead, the interest payment is treated as pre-tax money, and William will pay ordinary income taxes on the same loan amount twice over.
As Michael Kitces says, “401(k) loans don’t really pay yourself interest, they just add tax-inefficient dollars to your 401k!”
Tapping Home Equity
So, now let’s talk about home equity. First, you must have equity in your home available for you to utilize this option and lenders generally only permit the borrowing of up to 80% of this equity. Second, tapping home equity to fund one off expenses can be prohibitively expensive if you do not have excellent credit. Borrowers with FICO scores above 750 tend to receive the best rates. If you do not have equity in your home, or an excellent credit score, funding your one off expense with a home equity loan may not be the best option for you.
There are a few options to tap your home equity including a second mortgage, a Home Equity Line of Credit (HELOC) loan, and a cash out refinance. It’s important to know the difference between each option, which you can learn about here.
Breaking Down the Math
Consider that William decided to finance his daughter’s medical school tuition with a $50,000 flat-rate home equity loan instead of a 401(k) loan. The interest rate on the home equity loan is 5%, William is in a 33% tax bracket, and the home equity loan’s interest is tax-deductible.
Let’s compare the cost of borrowing for a HELOC loan versus a 401(k) loan. We will assume the headline rates of the 401(k) and HELOC loan are both 5%. However, a borrower will pay taxes on the 401(k) loan twice, once when they are paid their salary, and again in retirement when they withdrawal the pre-tax money from their 401(k). Thus the cost to borrow can be calculated by dividing the amount borrowed by (1 – current tax rate), or (borrow rate) / (1 – ordinary income tax rate). As an alternative, with the HELOC loan the borrower can receive a tax deduction on interest paid. The effective after-tax borrowing rate can be calculated by multiplying the amount borrowed by (1-current tax rate), or (borrow rate) * (1 – ordinary income tax rate).
Let’s refer back to William from our previous example. If William borrows money using a 401(k) loan at a 5% rate and his marginal ordinary income tax rate is 33%, then William’s after-tax cost to borrow will be 5% / (1-.33), or 7.5%. If William borrows the same amount using a HELOC loan and his marginal ordinary income tax rate is 33%, then his cost to borrow will be 5% * (1-.33), or 3.3%. Thus, the HELOC loan is the more tax-advantaged option for William’s financial situation.
Low Rates Make Home Equity Even More Attractive
Interest rates are nearing historic long-term lows and an individual with great credit will likely qualify for an exceptional rate on the loans they take out (sometimes as low as 4%). One of the greatest advantages of tapping home equity for your borrowing needs is that, under the right conditions, interest payments are tax deductible, which will reduce the loan’s overall interest cost for the borrower. Thus, William’s situation would be better suited for a home equity loan as he will pay less in after-tax borrowing costs over time than he would with a 401(k) loan.
If you’re expecting to fund a large expense, be sure to thoroughly research and compare your available options. While borrowing from a 401(k) may be the right choice for some, the long-term cost of its associated interest fees may outweigh its perceived benefits.
Remember, what you don’t know can cost you, and can potentially affect your long-term financial goals. If you have any questions, please consult your financial advisor, or contact a member of the WJA team for more information before you make a decision
Willis Johnson & Associates is a registered investment advisor. If you borrow from your 401(k) you have five years to repay the loan. If you lose or switch jobs, the loan must be repaid usually within 60 to 90 days. The IRS will count the loan as a taxable distribution if you don’t pay it back on time. You will owe income taxes, plus a 10% federal income-tax penalty if you’re younger than 59 1/2, on the unpaid balance.
This material is intended for informational purposes only and should only be relied upon when coordinated with individual professional advice. Please speak to an investment professional before implementing any advice here. Willis Johnson & Associates does not provide tax or legal advice.
Nick Johnson, CFA®, CFP®
Nick Johnson believes that financial planning is more than numbers on a balance sheet and a standardized process. People are unique and should be treated as such.
As Vice President and Wealth Manager at Willis Johnson & Associates, his goal is to really get to know his clients, all the while providing a proactive approach to comprehensive wealth management.