I always know I’ve written something good when I get hate mail. I have received numerous emails, tweets, comments, and responses about my post on 401k loans. All of them contain a twinge of mansplaining and are variations on a similar theme.
“But Blair, aren’t you paying back the loan with after-tax dollars that will then be taxed at withdrawal?”
Thanks for your concern, gentlemen. These comments imply that I have committed some cardinal sin of financial planning; paying tax twice on the same dollar. Yikes! Let’s examine the mechanics of the 401k loan repayment process.
First, the principal of the 401k loan, in this case, comes from pre-tax deferred savings. I haven’t paid tax on those savings yet, and I am not paying tax to borrow the money from the plan, However, I will pay tax to withdraw these funds later in life. Taking the 401k loan hasn’t altered the tax status of these funds. They were and still remain pre-tax savings that will be taxed as ordinary income when I take withdrawals in retirement.
The commenters are correct about the interest payments on the loan. I am making these payments with after-tax dollars, and they will be classified as pre-tax within the 401k account. This means I will pay tax again on these dollars when withdrawn later in life. Oh no!
But let’s examine the actual dollars and cents. The interest payments are not very large. I’ve had the loan out for four months and paid a total of $1,113 in interest. Realistically, it will be a few months before I sell the old house and pay off the loan. Let’s assume three more interest payments, for a total interest paid of $1,938.
If I earn 7.0% on my investments for the next 25 years, that $1,938 will grow to $10,519.
At the highest Federal tax bracket of 37%, I will owe $3,892 in tax to withdraw those funds. Hopefully, with good tax planning, I won’t be in the highest tax bracket, but if I am, that means my career went very well financially.
If I inflation-adjust $3,892 back to today, assuming an inflation rate of 2.5%, that’s a cost of ~$2,100 for making this terrible mistake.
Would it have been ideal to sell my old house first and avoid taking a 401k loan altogether? Absolutely. But that was not my reality. I have two young children (6 and 3). Have you tried selling a house while little children are living in it? That sounds like a nightmare to me. The house we wanted to buy, after a three-year search, was on the market. We needed to make repairs to our house to get it ready for sale. And gasp, I didn’t have a ton of cash sitting around to put 20% down on the new house. I’ve been saving for college, saving for retirement, paying for private school tuition, and so on.
I reiterate that there are many reasons to avoid 401k loans. Most of the time, 401k loans are not a good idea. However, using a 401k loan as temporary, bridge financing can be an easy, quick strategy. I would even argue that using a 401k loan for a down payment on a first home can make sense.
After all, we are not robots in search of absolute financial efficiency. We are humans who are trying to build happy and fulfilling lives, both today and in the future. This is what I love about being a financial planner. Real lives don’t follow textbook examples. Real lives are messy and sweet.
So thank you for asking, and thank you for your concern.