Mullooly Asset Management
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Mullooly Asset Management
Unmasking the Hidden Risks of 401K Loans: A Critical Financial Deep-Dive
Reconsider everything you've been told about borrowing from your future! In a riveting exploration of the often-endorsed 401K loans, Tom and I dissect a sponsored article by Principal Financial Group, challenging the sugarcoated narrative that these loans are a safe financial bet. The episode peels back the layers of this contentious subject, revealing the hidden truths and the pressing need for a robust financial safety net. We're debunking popular myths and emphasizing the potential dangers and long-term repercussions of tapping into retirement funds prematurely. This isn't your typical financial advice podcast; we're here to arm you with the critical thinking skills needed to question the status quo and make informed decisions about your financial well-being.
In this critical conversation, we address the stark reality faced by the average 401K loan borrower and the underestimated risks of such decisions. Consequences of defaulting on these loans aren't just figures on a balance sheet—they can have profound effects on both employees and employers, leading to a cascade of financial woes. As Tom Malouli, investment advisor representative with Malouli Asset Management, I remind our listeners that the insights in episode 466 are shared to spark personal reflection and should not be misconstrued as direct advice from Malouli Asset Management. We're here to provide clarity and thought-provoking content to help guide you through your financial journey with eyes wide open. Join us for an honest and unfiltered examination of 401K loans that promises to leave you better equipped to navigate your fiscal future.
Welcome back to the Malooly Asset Management Podcast. This is episode number 466. This is Tim Malooly. Here with me today is Tom Tom. What are we talking about today? Fake news? Fake or misleading news?
Speaker 2:Yeah, I don't like it.
Speaker 1:Yeah, we stumbled across an article in 401K Specialist and it was about 401K loans and they were gonna debunk some myths and we'll link to this whole article in the show notes if you wanna read it. But we're kinda just gonna break it down step by step and dissect what they're saying. I think it's important to note that this was a sponsored article. It was sponsored and written by principal financial group.
Speaker 2:Which does a massive amount of 401K plans.
Speaker 1:Right. So I think, first off, I think that's important. Sometimes you go to these websites and majority of them are from journalists writing just informational pieces. But every once in a while these websites kinda slip in a sponsored post and you gotta think about what the author is doing when they write it, or the tone, the side of the fence that they're sitting on.
Speaker 2:And, to be fair, 401k Specialist is an industry magazine, well, online magazine that we get, I think, daily junk mail from them and it's funny when you look for the author line. What does that say?
Speaker 1:It says, by principal financial group.
Speaker 2:That's astonishing.
Speaker 1:Yeah, I think. So. Having that information going into the article, it made me read it through a different lens. They wanted to debunk some myths about 401K loans. Essentially, the tone of the article seemed to be that there were a lot of negative connotations or misconceptions about taking 401K loans or the data surrounding the loans, of who's taking it. How many people are taking loans and I don't know. To me it kinda felt like they were not encouraging people to take 401K loans, but almost giving permission, saying it's not as bad as people think it is.
Speaker 2:Yeah, I think they were trying to, I agree. I think they were trying to remove some of the guilt and shame that sometimes comes along with taking a 401K loan. And so they start out the piece by talking about, since the pandemic, more and more people are taking loans from their 401K. Yeah, doesn't hurt that. The balances in their accounts are up probably 40% since the start of the pandemic. Well, unless they're all in bond.
Speaker 1:Right? Well, I mean it makes sense. Going through the time in the pandemic when people were losing their jobs or the economy was bumpy and money became an issue for people, the one place they could potentially turn is to their 401Ks to get some quick cash.
Speaker 2:I think the problem that, while principle talks about how easy it is to gain access to this money, it's a loan and loans need to be paid back, and so, while you might get a quick fix by taking $30,000 or $40,000 out of your retirement plan, you are signing up for 60 payments over the next five years. I don't know.
Speaker 1:Yeah, I think 401K loans can be a useful tool for people if they absolutely need to take money in a dire circumstance, but I don't think it's as good of an option as they potentially paint it out to be in this article. So they walked through a few myths. What was the first one that they had?
Speaker 2:The first one that they discussed was that 401K borrowers are frivolously using the money that they take out in a loan without care for their retirement plans, and what they retort is that the data shows that most loans are used responsibly to pay off debt and essential expenses, while saving for retirement continues to be a priority.
Speaker 1:A lot of people have it drilled into their heads that saving for retirement you need to do it. You have to do it. Why aren't you saving for retirement? How much are you saving for retirement? That it just continues to be a priority for people and I read this myth as they're taking a 401k loan and they're still putting money away for a retirement and they try and make that seem like that's a good thing. They're still able to put money away for retirement. But if you take a step back, it's like well, why did they need to take this 401k loan in the first place? Because they needed money. So if they, maybe if retirement wasn't as high of a priority on their list, they wouldn't have been piling as much money into the 401ks they were. They would have had more money in their paycheck.
Speaker 1:I think the financial priorities for a lot of people are out of whack and that kind of almost all of the myths in this article. That was my takeaway. It's well, if they didn't have to take a 401k loan in the first place because they were managing their cash flow better, managing their budget better or right sizing how much they're actually putting into this 401k in the first place, they wouldn't be in this position. So I think that's for me that that was. It's like well, 401k loans aren't the boogeyman, they're not bad. And if you need to take it, take it, but like, try to not put yourself in a position to where you need to take one. That should be the first step, in my opinion.
Speaker 2:I completely agree. I think that if you're taking a 401k loan or some type of loan from your retirement plan, it's because you have a cash flow problem, it's because you don't have an emergency fund. And as we go through each of these myths that they talk about, the answer comes back over and over. This is a cash flow problem. This is you didn't have an emergency fund, you didn't have savings and reserves. So many people start their job or their first job, say they're in their early to mid 20s. Somebody tells them the first week that they're working there hey, sign up for the 401k and put as much as you can in, because that's going to be really important.
Speaker 2:Social security isn't guaranteed, according to some guy, by the coffee pot.
Speaker 3:You're on your own for retirement.
Speaker 2:There's no pension anymore, so you got to save everything that you can and people get scared into saying, oh my goodness, I better put like 10% or 12% of my entire paycheck into this, and then they find out that they're going to buy a house and they don't have the cash. Yeah, it's a problem, right, one of the things before we get too far into this. I thought it was clever that principal had this little illustration on the first or second page. People link to this in the show notes how they try to blame that increased loan requests came with inflation.
Speaker 1:Right Visually you can see they have the percentage of loan requests and then how, the percentage of inflation over the years from 2019 through 2020, 21, 22, and now the first half of 2023. That is the most recent data that they had, but it doesn't illustrate the point. I think that they thought it did, because the loan request percentages each year go from 8% to 7% to 8% to 9%, while inflation is moving from 2% in 2019 up to 7% in 2021 and 2022. And now the loan percentages drop in 23 along with inflation. But it doesn't line up or make the point. I think that they were trying to Right.
Speaker 2:Yeah, they can't blame this on inflation. Yeah, and I think that's really the takeaway. So they also tied in this survey from the Employee Benefit Research Institute In our business we know it as EBRI A survey last year Workplace Wellness Survey showed that there's a problematic level of debt, including credit cards, medical expenses and student loans, and that's where people are tapping into 401k loans.
Speaker 2:We try and counsel folks that are if they're considering taking a loan from their retirement plan. If it's an urgent need, well, you got to us kind of late. There's not much we can do. If there's an arrow stuck in your neck, you got to address that. But if it's something like, oh, I want to pay off my credit card, we've done. I've lost count of all the videos and podcasts that we've talked about where you didn't get $40,000 in credit card debt overnight. It rarely happens that way, and so you can tackle the problem the same way, and one of the things that we do say to some folks if they're in a job that pays well and they have good cash flow, maybe what they want to consider doing for a year or two is not contributing to their retirement plan. Principal would never say that, right, maybe they should just take the money that they were driving towards their retirement plan and take that money and pay off Mr Visa.
Speaker 1:Yeah, it's difficult because I think, like you said, sometimes these things happen or the debt has already been accrued and there's not much you can do about it, and then, once you're in that boat, it might make sense to actually take a 401k loan so that you can pay one lump sum off, because your credit card is compounding at 29% and this loan that you're going to take from the 401k plan is you're paying it back at 5, 6, 7%, so you're trading debt at that point, but you're just lowering the interest rate. So at that point it could make sense. But, like you're talking about, Interest rate arbitrage.
Speaker 1:Yeah, you try and head off these problems before they actually occur, and I think that's the main point. But I guess it's good to hear that people are not frivolously spending the 401k loan money. That part of the point is good to hear that they're using it for things that are important.
Speaker 2:So when we talk about 401k loans and I know we're kind of veering off from the article but the maximum that you can take from a 401k or other retirement plan is $50,000 or half the balance of the plan. So if you have less than $50,000, say you've got $40,000, the most you could take would be 20, half of the plan. The maximum dollar amount you can take out is $50,000. So $50,000, I don't have a calculator with me but current rate of interest on a loan like that you are talking about, if you take out the max $50,000 because you want to use it as a down payment on vacation home, second property, car, I don't know but you're talking about a monthly payment, 60 equal payments of something in the neighborhood of $1,400 a month. And so I am again going to use the word astonished when I see principals say that a strong majority 83% of people continue contributing to the retirement account while taking a loan.
Speaker 2:Well, how do you afford that?
Speaker 1:I mean. The point being they said they're contributing at the same deferral rate. So, they were deferring, let's say, 10%, whatever into their 401k, and then they take a loan and then they continue sending in 10% from their paycheck into the 401k. To me that's part of the problem. They painted it as that's a good thing for people.
Speaker 2:So if you're planning administrators, yeah.
Speaker 1:I mean it's good that. I guess it's good that people are saving for retirement, but if it comes at the cost of their current cash flow needs, then Another thing that we always talk to With people that that try and do what we illustrated before, where you take a lump sum to pay off credit card debt. It's a one-time Hit to wipe the slate clean, but it doesn't fix the behavior that got you into that mess in the first place. So a lot of times we see people you know do do something like this to pay off a big lump sum and then a few years down the road they're back in the same back in the same boat. So I think, like we've said a few times here, it's Fixing the behavior and fixing the issues ahead of time so that you don't put yourself into this position.
Speaker 2:Yeah, the one-time bailout hardly ever works.
Speaker 1:Yeah, it's putting a band-aid over it, but it's not actually fixing the issue of like what? What caused the yeah, the pain you?
Speaker 2:have a spending habit or you have a cash flow problem in general.
Speaker 2:That needs to be addressed and we try and get folks to, once they clear up all this loan business, to maybe scale back what they're putting into a retirement plan and Start building up a reserve on the outside right where they can deal with the significant health expense or a car repair or some kind of situation where they're gonna need cash right now. Right, so that's a problem. Yeah, okay, so the the second myth that they were trying to break in this article is that loans are mostly taken by younger and lower income participants, who use them like a revolving credit line.
Speaker 1:Yeah, they went on to say that the data Pointed out that the average 401k borrower is age 43.
Speaker 2:Just about the time you start getting a significant balance in your plan.
Speaker 1:Yeah, we were talking about this before the microphone turned on and I likened it to when there's statistics saying that you get in the most car accidents driving within a five mile radius of your house and it's like, well, yes, because that's where you do most of your driving. It's like the statistics are it kind of you have to like bend your brain around a brain around it for a second. It's like, of course, most of the accidents happen where you do most of your driving. And it's the same thing with this myth it's the people that actually have been putting money into their retirement accounts for a long time and have money To take out of their retirement accounts are the ones taking money out of their retirement accounts. No way, that's crazy. You mean, the 25 year old who just enrolled in their 401k six months ago and has $1,700 in there isn't rating their 401ks for loans.
Speaker 2:Don't laugh.
Speaker 1:You and I have seen that we have, but it's like you got to be kidding me. That's not. They're not the majority of the people.
Speaker 2:Wow, yeah, crazy, groundbreaking stuff so another myth that they talk about is that many 401k borrowers will leave the company default on their loans and this puts them at risk of being assessed the penalty and taxes and Creates additional administrative burden for the employer. That's not a myth. In fact, all of the things that they said in that run-on sentence are pretty accurate but they're just saying what they put in front of that statement was most people who take loans are planning on leaving the company.
Speaker 2:No but if they do default on their loans, they will be assessed penalties, they will be assessed taxes and it does create administrative burdens for the employer. So all of that true.
Speaker 1:Yeah, and when you go back to some of the other points that they made, that people aren't spending this money frivolously, which is a good thing, but the 401k loans being taken are being used for important things. So you would hope that the people taking the loans are at least doing their research or they anticipate paying back the loan and they wouldn't get themselves involved in something like that frivolously, to use their own word. So, yeah, that makes sense to me and that's a good thing to hear. You don't want to see people just taking these loans all willy-nilly and then leaving and getting themselves into an even bigger mess.
Speaker 2:It is worth talking about what happens when people do leave the company or if they default. How do you default on a loan like that and will that affect my credit score? These are real questions that we get asked. Yeah if you default you miss a payment.
Speaker 1:Usually, most plans have a certain number of payments that you miss. Some are very strict where, if you miss one, you default on the entire thing and then the rest of that loan that you haven't paid back yet becomes fully taxable. It's like you take a distribution from your 401k, so it's taxable, and you're penalized on top of that too.
Speaker 2:If you're under 59.5%, you're going to be paying 10% on the distribution and you're going to get a 1099R the next year for taxes owed. That's the worst part is that say, you took this lump sum of money in a loan to pay off a credit card. You don't actually even have the cash.
Speaker 1:And then, when you get assessed the penalty, you do put the penalty on your credit card.
Speaker 2:Yeah, that's how you're going to have to pay Uncle Sam for that.
Speaker 1:So they made some points in the article I think that were technically correct and if you do find yourself in a position where you have to take a 401k loan, what they were saying is true and it makes sense. My issue with it is that it doesn't address the fact that there are so many things that you can tweak in your own cash flow and budget and personal financial situation to avoid having to take a 401k loan in the first place.
Speaker 2:Yeah, I think a lot of people misunderstand, or never stop to learn, all of the ins and outs of these retirement plan loans. So when you do take a loan from your retirement plan, that money is coming out of your investments. It's coming out. When you take $40,000 out or $50,000 out of your plan for the next period of time, while that loan is being repaid, that money is not doing anything for you, and I know this came up in our last discussion as well. So when you take the money out, you pay yourself some interest, but you're also paying the plan administrator for the cost of the loan as well.
Speaker 2:I cringe when I hear people say, yeah, but you're paying yourself. You're not paying yourself the whole thing, and so the typical rate of interest that you're charged is, for many plans, prime rate plus one, and it becomes a fixed rate on the day you take the loan out. It's not a variable rate like Visa card. So right now, prime rate at banks in the United States at the time we're recording this, is 8.5%. So you are now paying 9.5% out of post-tax cash flow. You have to have the money sitting in a bank so you can pay it back each month most times when you're doing a 401k or retirement plan loan, you can't do it through your payroll right. It has to be through a bank, so you have to have the cash to pay back your own loan.
Speaker 1:Yeah, the loan that you took with pre-tax dollars. Most likely, yep, yeah now down the road.
Speaker 2:When you retire and you take money out of your retirement plan, the interest that you paid on that loan will be post-tax dollars, not the amount of the loan plus the interest, just the interest. So the interest you're gonna. That's not gonna be eligible to be rolled over to, say, an IRA or some other retirement plan, so that money comes in a separate check Because you took loans. There are lots of situations Some of you and I both read this in the article where people go from the payoff one loan and they'll start another one right away. Yeah, this is a cash flow Scenario that really it should be addressed. But yeah, in 2023, a lot of stuff, a lot of stuff slips through the cracks.
Speaker 1:Yeah, I think there is a lot of information there with 401k loans, trying to avoid them if possible, but if you have questions about your 401k or loans, you know.
Speaker 2:Feel free to reach out to us and we'd be yeah, before you get into a situation, hopefully. Yeah where you're, where you're Considering taking it out.
Speaker 1:Yeah, that's a good place to stop for now. That's all we have for episode 466 of the podcast. Thanks for listening.
Speaker 3:Tom Malouli is an investment advisor representative with Malouli asset management. All opinions expressed by Tom and his Podcasts guests are solely their own opinions and do not necessarily reflect the opinions of Malouli asset management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Malouli asset management may maintain positions in securities discussed in this podcast.