Q&A Why Taking a 401K Loan Can Destroy Your Wealth

Hey there, real quick before we jump into the episode, listen, if your earnings treadmill hasn't set you free yet, running faster won't either. Listen, hustle without principles just going to burn you out. So here's what I want for you. I want you to join me for my money machine experience Live. It is three free trainings. Deep dive into how to escape the treadmill and build a money machine that actually works for you. All right, Grab your spot here by going to moneymachinelive.com and I'll see you in the free training. All right, here we go. Here we go. Listen, here's the deal. You know, people say invest in your 401k. 401k, 401k. Invest in your pension. I tell you to do it. I want you to be putting away 20 to 25% and sometimes as much as 30%, depending on your fat, your age and stage in life and what you got, you know, away for your future. And, you know, we follow something called the wealth priority ladder. And how do you do that? It prioritizes each and every dollar. But questions have come in actually multiple times in the last handful of weeks about, hey, I need to pay some things. Does it make sense to borrow from my 401k? They told me I could borrow from my 401k. And here's the interesting thing to realize is that when I started to look at statistics, people are struggling right now. The average credit card balance is $8,000.

The withdrawals from hardship, withdrawals from 401ks are higher than they've ever been. They're 36% higher than the prior year. Almost 16,000 hardship withdrawals. The Employment Benefit Research Institute is saying that, that 20% of people have an outstanding loan. Now, does that make it right? Does it make it wrong? Here's what we know. The federal law allows you to borrow the greater of 50% or $50,000 of your vested balance of your 401k. Yeah. You have to pay it back in five years. And the interest rate's typically going to be prime plus a point or two. So the interest rate on these things are going to be 5 or 6%. And the idea is that, well, I'm paying that interest back to myself. Well, not so fast, because there's some things we need to think about. Okay, and, and so we're going to, we're going to talk about, you know, what are first the pros. You know, it's easy. It's, you know, credit. Ba ba ba ba ba ba ba. And now there's the cons. Okay, so then the question really is, what does this look like? So let's, let's look at what this can do for you in the process. Okay? So let's just make some assumptions and now let's look at what the results are. Okay?

And this could cost you 139,000 bucks.

So a simple loan could cost you $140,000 in your financial future. Okay. And so now all of a sudden, you look at it through a different set of does it make sense to borrow from your 401k? I think it only makes sense as a last ditch effort, actually. It's one step above hardship withdrawal. So you got hardship withdrawal as the last, last vestiges of what you want to do. And just above that is 401k loan. Hey, I hope that this helps. This is the Affluent Entrepreneur show for entrepreneurs that want to operate at, at a high level and achieve financial liberation. I'm your host, Mel Abraham, and I'll be sharing with you what it takes to create success beyond wealth so you can have a richer, more fulfilling lifestyle. In this show, you'll learn how business and money intersect so you can scale your business, scale your money, and scale your life while creating a deeper impact and living with complete freedom. Because that's what it really means to be an athlete. Entrepreneur.

All right, welcome to this episode of the affluent Entrepreneur show. This one, like I said, we're going to talk a bit about something that I think is.

An issue that I, that I think is getting worse and worse, even though we're not hearing about it in, in the press or the media or anything like that, is that I think that there's a level of uncertainty financially in, in this, in society, our economy, in the world today. I mean, any way you cut it, even though our unemployment rates are down below 4%, our debt rates are far greater. You've got a time where right now student loan debt payments have, have restarted. People are struggling to pay student loans now. Some of those Student loans are 6, 7, 8%. Mortgage rates are up above 8%. Um, the, the credit card rates are up close to 30%. So I mean, we're getting. Debt is getting more expensive. I know this is, this is the motivating part of this, this whole episode. But, but I want us to understand the dynamic of what we're up against and why people are looking towards their retirement accounts as the possible savior in this, in this whole thing. Because if I look at some of the statistics from Motley Fool, Motley fool says the average credit card Balance is around $8,000. I've seen it as low as 5, but it's $8,000. Household debt. Household debt in the US is over 101,000. The average mortgage is 236,000. HELOC, a home equity line of credit, which I'm doing a separate episode on, on those, those things is over $41,000 on average. Auto loans. Auto loans, $22,000. Okay. Is the average loan balance on an auto loan. The average new car payment is over 700, almost $750 a month. You know, and, and then there's personal loans. The average personal loans, according to Motley fool, is over $11,000. That being said, is that what that tells me is that people are trying to figure out how they can pay for their lifestyle, how they can support themselves. And if their income isn' level that it needs to be, then what they do is they borrow to do it. And so one of the things we need to understand is how do we navigate this? Because here's what's happening is people are struggling to just pay their daily bills. Now this is why in the affluence blueprint, when we talk about this, that we have something called the Wealth Priority Ladder. What do you do with each and every dollar that comes in that you don't turn around and, and just arbitrarily throw some dollars at it? You know, specifically, every dollar has a job description. Every dollar knows exactly what it's going to be used for. So you use it that way. And we know it up front. You know, is it going towards debt, Is it going towards a mortgage? You know, you can call it a budget, you can call it a cash resource plan, which is what we call it. You can call it a spending plan. But what I want to do is give you permission to, with the Wealth Priority Ladder, give you permission to do what you need to do with the dollars that you have. Now, two sides of the equation, let's face it. You've got the expense side and you've got the income side. We need to balance these if we're going to be on the path to financial freedom. We need more income than we have expenses. And we need to take that income. We need to invest it. It's why we have the earnings machine and the money machine. There's two machines you need to build. And when people struggle, they start looking for other places for cash. Now, one of those places is a 401k, because you can borrow from a 401k. The federal law allows you to borrow up to $50,000 or 50% of your vested balance, no more than $50,000, okay? And.

That means that you can tap into your retirement. And when you pay that back, and you have to pay it back over a minimum of five years, you pay it back with interest. And most people look at it and say, well, I'm paying myself interest, so what's the harm in that? You know, I'm going to borrow it out, I'm going to use it for whatever I need to use it for, and then I'm just going to make my payments over five years back to myself and pay myself interest. And so there are some things, some pros and cons to it. I want to walk you through an example. I want to do this because this question has come up multiple times, just in the last, last handful of weeks about, hey, I want to pay for this, I need to pay for this. I'm going to borrow from my 401k. Is it a good idea? Okay? And I know that some people will say it's a good idea. I'm going to tell you that I don't think it's a good idea. I think that it can destroy your wealth. You're going to see the math behind it if you're not careful.

But it may be the only resort. Because if you have no other sources of cash, you know, first things first. I'm going to ask you to look at, if you're looking towards your 401k for financing, then the first thing I'm going to ask you to do is take a look at your expense structure. Take a look at where your spending is. Look at things from a wants and needs standpoint. Do I really need this or is it simply a want? Am I getting joy out of it? If I'm not getting joy out of it, why am I spending money on it? Those kinds of things, eliminating subscriptions that you're not using and starting to bring the cash in. Second is, we got to look at our income, okay? We got to look at our income. To sit back and say, is there a way that I can scale my income? Is there a way to leverage our income? We talk about the revenue scalers, the eight revenue scalers in the affluence blueprint to help people understand how do I increase my income? To give me not more spending money, more investing money, to give me more room in my paychecks than I have month, month to be able to do that from, for that perspective. So I don't want the 401k to be the first resort. I think it needs to be the last resort. All right, so I'm gonna jump, I'm gonna jump to, to some slides. We're going to walk through some things and then, then let's talk about the pros and cons of how this thing can play out. And then let me walk you through an example. And I think the math will, will explain it all to you. Okay, so the first thing is this. Let's just talk about the pros. And when it comes to the pros, the first thing is this. It's easy to get. It's your 401k. Now let me be, let me be really, really clear. If, if your plan, your 4 way 401k plan has to allow for 401k loans, some plans don't. Okay. If it's not in the plan document, then you may not even be able to have this opportunity to do it. So, but, but most plans allow for it. And so when you look at it from that perspective, it's easy to get. It doesn't take a lot. You're going to fill out some paperwork. It's with your 401k, you'll get the money and you'll go from there. The second pro is, is that ain't no credit needed. They're not running your credit, they're not checking your credit, they're not looking at it. You don't need to have a big credit score. You just need to have a vested balance in the 401k and that's it. Okay. If it's vested and it's in the plan, you may be able to borrow it. Okay, then the third thing is that you're going to set it up on automated payments. So what typically happens is that because it's a 401k loan, they will automatically take a payment back to the loan out of your paycheck on a regular basis. So every time you pay yourself, there'll be a 401k payment going back to the loan. So it's automated and it's going to get paid back. The fourth is this. And this is what everyone says, well, I'm paying interest to myself and I get it. Yes, you're paying interest to yourself. But is that really who we want to pay interest to? Because there's a part of this that you got to understand and we'll walk through the math on it that you're actually paying interest that's actually more expensive because you're paying with after tax dollars. I'll walk through the math on that in a moment where you start to really look at, from, from that perspective and understand that there is a cost to it beyond, beyond that. So you're paying interest to yourself. It can be cheaper than getting a personal loan or some other loan. Maybe, maybe when we do the math, you'll, you'll see where I'm going with it. Because in some situations there is actually a lost opportunity that actually is far more costly, far more costly than, than the interest itself.

You have a five year payback period, so you can borrow this out, but you have to get it paid in five years and there's no prepayment penalty. So you can pay it back sooner than the five years but no longer and you don't pay tax on it. So unlike, unlike if you drew out of your 401k, that's a distribution. And there are hardship distributions that you can do.

From a 401k, but that's an actual distribution and that will trigger a tax. If it's a hardship withdrawal from a 401k, you won't get hit with the penalties. Remember, you can't draw from your 401k typically until you're 59 and a half. Okay? So if you're below 59 and a half, they're going to hit you with a penalty because all this money is being put into this account long term for retirement, not for expense paying. But if, if you need it because of hardship, they will give you the ability to get it out, but you'll have to pay tax on it and you'll avoid the penalty. So things like medical expenses are one of the hardships that qualify. A natural disaster, the purchase of a primary residence, eliminating the possibility of eviction or foreclosure on a property, all those are hardship that you can use as an exception to do a hardship withdrawal from the plan and avoid the penalty. You will not avoid the tax, but you will avoid the penalty. Now, unlike a loan, you're not going to repay this. It's out and it's out for good. You're not going to put it back in the loan. You're borrowing and you're going to put it back in. And I think that we need to realize that that's the difference when coming to that. So that's the pros. What are the cons? These are the things that I think we need to think about. Okay, the first con is this. You lose the growth. So if you're gonna draw out $50,000, you know what ends up happening is that that $50,000 is not growing, it's not invested. You took those dollar bills out of service. Now you might go, pamela, I'm paying interest, I get it. But interest isn't the same as growth, okay? And, and it's coming from one pocket to the other. The growth in your, and the compounding in your account is at a far greater rate than the interest you're paying. Okay? In the long term, we have downturns, 20, 22 stuff went down, all right? But it's coming back up in 20, 23 and beyond. And if you look long term, the market goes up 8 out of 10 years, okay, on average 8 to 11%, depending on where you're looking. You know, it goes up.

On a long term basis. And so what happens is that when you take the money out, you lose the growth on the money that, that you took out. Okay? The second thing is this, and this is where I think we need to be aware of. This is the thing that a lot of people don't realize.

You lose the ability in some plans to make contributions or get the match. So here's what I mean by this, is that some of the plans, when you take a loan out, when you take a loan out, they, while that loan is still outstanding, you are no longer able to make contributions to your 401k.

Because the loan's outstanding. The only thing you can do is pay back the loan over time. That means that not only do you lose the growth on the money you took out, but you no longer have the ability to contribute to build anything for the future. And if you're not contributing, you lose the match. So if your employer is matching 3%, you lose that free money. That's a huge cost. And you're going to see the math behind that in a moment. And a lot of people don't realize it. And the ones that I've talked to said, are you aware of, of whether this. I don't even know. Well, we need to find out.

The interest you pay is after tax. Here's what I mean by this. So, so when you pay interest on this loan, you're going to make some money, okay? You're going to make some money. So let's say that your interest payment on the loan is $200, okay? So you're gonna have to pay, pay $200 back to the 401k.

But that's coming from your check, which means that in order to pay the $200, it's going to be after tax. So I would earn the money they would take the taxes out and then I would have to have 10, $200 left after that to pay the loan. So if I was at a, call it a 30% tax bracket, okay, you're going to need to earn 230 to $250.

To pay 200 after taxes.

Not very readable, but.

$250, okay, depending on your tax rate, you'll need to earn 230 to $250 to net 200 to pay back.

That's what I mean, that, that it's actually more expensive than what you think. So you lose the growth, you lose the contributions and matching potentially and you pay the interest back. Yes, you're paying to yourself, but you're paying with after tax dollars. Then the amount is limited. You can only take 50k max. Okay, 50k max or 50% of the vested balance.

And this is the other thing that can get a lot of people. If you have a job loss or separation, if you lose your job or decide to quit and the loan is outstanding, you have 60 days to pay it back.

So it accelerates it. If you can't pay it back within those 60 days, then what they do is they say, well, the balance is a distribution. And if it's a distribution.

You no longer have to pay it back. But now you're hit with a tax and you're hit with the penalty. So if there's a chance of job loss or you're thinking of quitting during the time that there's a loan outstanding, you could trigger a tax that, that could hit you at, at the tax rate you're at, plus 10% on the penalty. And if you're in a state like I am, they charge percent penalty. So you may have a federal and a state penalty on it. And, and that may be completely out of your control because if your company decides to separate you or they decide to do a layoff or whatever during that time and you can't pay it back in 60 days, you have a tax issue, okay?

It can trigger the tax and penalty which is, which is the accelerated loss. And then the last thing is this. I actually think it can lead to bad habits. Remember wealth creation. Wealth creation is all about.

Behaviors. It isn't, it isn't the money you make, it's what you do with the money you make. It's a behavior issue. Okay? No one has money issues. We have behavior issues. It's, it's a. Your money situation is a result. And I know this is confronting, but your money situation is a result of Your decisions, your habits, and your behaviors from the past. And if you want a different money situation, we need to make different decisions, develop different habits, and have different behaviors. And what happens is that if we see the 401k as our savior, that we can always go dipping into, aside from the costs, and we're going to go through an example here in a second, then what's happening is we're enabling bad habits because we're living beyond our means. Look, I get it. Stuff happens. Stuff happens. You could have a medical emergency. You could have, you know, a house emergency. Things happen. And if we're not prepared for it, we have to find a place to, to pay for it. This is why the wealth priority ladder and the things that we do about building the Comfort Fund and the Peace of Mind Fund and giving you the liquidity so we don't have to do this is so, so vitally important. And, and yet we, we kind of live at the edges of our check or the edges of our credit cards, which we need to be careful about moving forward. And so I, I feel like this can develop some bad habits if we're not careful. Now, let's look at some things. Let's, let's bring this home with an example. I want to do some math for you. And, and let's see what that, what that looks like. So you can see this. All right? So we're going to make some assumptions on, on this example. Let's just look at it and say annual salary, you earn $100,000, okay? So you earn $100,000. You're going to contribute the max, okay? Right now, the max is 22,500. If you're below 50 years of age, okay, you're over, you can contribute 30,000, okay? So you're going to contribute 22,500. The employer match is 3%. Okay? So they're gonna match the first 3% in there. You want to borrow, and you're gonna borrow $50,000. You're gonna go to the max, okay, $50,000. Now, that means that you have to have at least vested in your plan a hundred thousand dollars because you can only borrow 50% of the plan balance, okay? So you're gonna borrow $50,000 for five years at 5%. And, and so what is that going to play out like? Well, here's what it's going to play out like over time.

You're going to have a monthly payment at 5%. Five years, $50,996.

And you'll pay a total interest of $9,738. Now remember, remember that's after tax. So if I'm in a 30% bracket or something like that, in order to pay the $9,700, I probably needed to earn 12,000 or $11,000 to make that payment after tax.

So the balance with the loan.

And no ongoing contributions or match at the end of five years. So let's look at this. You start out with a hundred thousand dollar balance in your 401k when you borrow 50,000.

And now you're going to pay that money back at996amonth. And at the end of five years, you've paid the whole loan back and the account was investing. But during the time that that loan was outstanding, you didn't make any contributions. The 22,005 you couldn't make because of the plan documents said you couldn't and there was no match. So you lost the 22,005 plus the 3% and the growth on the 50,000. At the end of five years, you actually will have $143,752. So if you look at it, you go, well, wait a second. So I started with a hundred, I borrowed the money. After five years, I end up with 143, 144,000. It's not so bad.

No, it's not so bad until you look at the other side of it. If we didn't do the loan and we continued the contributions and we got the match, guess what? You end up with a situation where you now have $283,000. You almost have double the money that you would have otherwise had. This is why I look at this and say, look, taking a 401k loan at what you think is 5% can, depending on the terms, cost you a whole lot of wealth if you're not careful about it. Okay? The fact is, is that this, under this scenario, the cost, the potential cost is $139,000. $139,000. These are the things that we don't think about. This is why I look at this and say, first off, last, last resort, hardship withdrawal from the 401k. Second to last resort, taking a loan from the 401k, especially if you can't continue contributions or you lose the match because it's not just the interest that you're paying now, you're paying the interest. But remember, it's after tax. So even the 5% is a little more expensive. But if you lose the match, you lose the ability to contribute. The cost to you is absolutely astronomical. If you're not careful, I get it. You might look at things and say, I ain't got no choice. Now. Understand that things happen, but we need to do it is do it strategically and do it with a plan. And if we have to do something, then we'll make it. We'll make it work for a short period of time, but we're not going to carry it out the five years because again, if you lose the job or there's a separation, we can trigger a tax which is insult to injury. So I hope that this answers this question about should I borrow from a 401k? And I. I'm trying to be very empathetic and compassionate to those that maybe are in a financial difficulty and you're looking at it and saying, I don't have any other choices. I get it. And maybe you don't. Maybe you do. I'm going to challenge you to examine that. If you're thinking of borrowing from your 401k, I'm going to challenge you to look at it and say, does it really mathematically make sense? And is there another avenue? Is there a way that I can increase my income? Is there a way for me to scale some things? Is there a way for me to maybe sell some things? If I looked at some of the technology I got floating around my office and all that stuff that I'm not using, I could bring in some cash and use it. Is there a way to sell some things? Is there a way to cut my expenses? Don't go to the 401k as the first resort. Go to it as the last resort and hopefully never, because I don't want you to destroy your financial future. That's truly robbing your financial future for your today. All right. I hope this helps. This is a difficult topic. If you're in that situation, if there's anything I can do to support you, anything I can do to guide you, make sure you reach go to askmelnow.com you can leave me your questions. We'll bring them on here just like this one and we'll try to give you some guidance along the way. I hope you found this of value and I look forward to seeing you on the road and my speaking and around in one of my other episodes of the Affluent Entrepreneur show. And until then, always, always strive live a life that I live to you. Thank you for listening to the Affluent Entrepreneur show with me, your host, Mel Abraham. If you want to achieve financial liberation to create an affluent lifestyle, join me in the Affluent Entrepreneur Facebook group now by going to melabraham.com group and I'll see you there.

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