JoeTaxpayer

A regular reader of my blog kindly pointed me to an article in Smart Money titled “401(k) Debit Cards Can Put Retirement at Risk” in which we are introduced to a debit-card like product which taps your 401(k) instead of your checking account. Although I wrote back in May’s “401(k) Loan bad for your (financial) health?” that loans were not absolutely bad, it depended on many factors, I think that such easy access is the flip side of the coin, almost certainly a bad thing. There are times I walk the fine line between wanting ‘big brother’ to establish just enough regulations to protect people from their own irresponsibility and wanting no such laws at all, caveat emptor still applying. Here, I’ll make the distinction between a one-time 401(k) loan used to help with the purchase of a first home, bridge the gap of income for an unemployed spouse, or a refinance of credit card debt combined with a change in lifestyle. Of course, paying off the cards with the loan, then charging up the cards again is no better than using a 401(k) debit card in the first place.

As the post title suggests, my feeling on this product is that it gives the consumer just enough rope to hang themselves.
Joe

written by JOE \\ tags: 401(k) loan, Credit, credit card, Finance, income, money, Retirement

There is a ‘rule of thumb’ out there that one should save 3-6 months salary (net, I assume) and from the near 16,000 Google returns on “emergency fund” “rule of thumb”, it would seem this is a hot topic among financial concerns. At Master Your Card, Kristy on Monday discussed the importance of the emergency fund, and while I agree with her that you shouldn’t put those funds into stocks, which may or may not be down at the very time you need the funds, I am concerned about the priority most attribute to the fund.

You see, most financial rules, are just that, generalizations that may apply to many/most of the readers of such advice. It’s easy, however, to offer examples where the rule(s) need some modification once the rest of the situation is understood.

For emergency funds, first, does your company have, and do they provide any matching contributions, to a 401(k)? If so, this is my highest priority. Some companies match as much as the first 6% of an employees’ salary deposited into their 401(k). On $50,000/yr, that’s $3,000 the company will match against your $3,000 deposit. In the 25% tax bracket, your net cost is only $2,250. Let me spell this out carefully - you are out of pocket $2,250, but now have $6000 in your 401(k)! Do you see why this is my top priority? Should you fund an emergency fund first, or take $2,250 and turn it into $6,000? If you lost your job, and had to take it out next year, you will likely drop to the 15% bracket, and after the 10% penalty for withdrawal, you still take out $4500. A side benefit, also subject to dispute, is that with $6,000 in the 401(k), you now have the ability to borrow $3000 back out, at 7-8%, and use that loan to knock down the high interest credit card debt. Yes, there are those who advise against the 401(k) loan, but in this scenario, it can be part of a kick start to both your retirement savings and debt reduction plan.

From a completely different perspective is an article on MSN titled “The $0 emergency fund“. I think that may be taking it a bit too far.
Joe

written by JOE \\ tags: 401(k), 401(k) loan, emergency fund, Retirement, Savings

The June Kiplinger’s magazine ran an article, “Raiding your 401(k).*” It advises against borrowing from one’s 401(k) and cites a T. Rowe Price study suggesting that someone borrowing $10,000 for 5 years (at age 35) will be short $145,000 at retirement even after paying back the loan. At 10%, $10,000 would grow to $131,100 in 27 years, that’s just math. Maybe they think this guy will retire at 63, not 62. But he did not take a withdrawal, he took a loan. My 401(k) charges 6.5% for a loan, credited back to the account. This means a 3.5% hit to the return on that borrowed $10,000. The account will come up short about $900 for having had the loan outstanding. Still using the 10% return, the retiree may find he is short nearly $13,000 at age 62, certainly not $145,000. Someone at T Rowe hit the wrong key, and none of my friends at Kiplinger’s catch this?

Think about this, though, the story cannot just end there. I can make the case that what matters is where that $10,000 loan went. Did the person buy a plasma TV and sound system? Or did he pay off all his credit card debt (at 24%) and start fresh? I can add to this - perhaps he was paying $288/mo and would have done so for 5 years to pay off the cards, but now is able to pay only $196 to the 401(k) loan, and use the extra $92 as an addition monthly deposit to his account. He is in the 25% bracket, and deposits a full $123 (which is the gross amount that nets him the $92) to his 401(k) and it’s matched by his employer, dollar for dollar, so at the end of year 1 he has nearly $3000 more in his account which more than makes up for the $350 hit he has from the loan itself. By staying on this path, he’s actually ahead by over $150,000 at retirement time.

As with any example, your mileage may vary. There is just one point I’d like you to take from this post. In finance, there are few absolutes. For every person who uses their 401(k) loan wisely, there may be five who blow the money and run up their credit cards again. But just as I take issue with Dave Ramsey’s statement that ‘responsible use of a credit card does not exist’, I feel that there are wise ways to use loans, 401(k) or otherwise. While I admit that a short article appearing in a magazine cannot cover every possibility, the one missing (and most important question was ignored - what does the borrower do with the money?

Joe

*The article is not yet available on line. As soon as I am aware it’s accessible, I will link to it.

UPDATE - I made an error here. (I prefer to leave the error in tact, above, but add this footnote.) In fact, the article did state “assume contributions stop for the life of the loan, as usually occurs”. This would make the math work, although I still take issue with these assumptions. I plan to revisit this subject in a future post.

written by JOE \\ tags: 401(k), 401(k) loan, credit card, Finance, Inumeracy, kiplinger's magazine, Retirement, saving