401k Loans Just Don’t Pay

I had lunch with a friend the other day and somehow we got on the topic of weddings (I know, strange topic for a couple of manly men), and in particular his wedding almost 10 years ago. He shared with me that they withdrew $15,000 from his 401k to pay for it.

He seemed surprised when I mentioned that in the long run they likely paid close to $100,000 for that wedding when considering how that money would have grown.

I showed him a little investing tool called the Rule of 72. In a nutshell the Rule of 72 is a quick calculation used to determine how long it will take for an investment to double in value. There are a few presumptions that need to be made when assessing this, but it is close enough for an estimate.

Years to Double Investment = 72 / Estimated Compound Interest Rate

Lets use my friends example of the 15k they removed from his 401k to pay for their wedding. As it stands today, his money would have likely doubled since he removed it roughly 10 years ago.

We can assume a compound interest rate between 8% – 10%, as this is generally the rate of return for the S & P 500 over multiple decades. Here is what the math looks like:

9 Years = 72 / 8

My friend seemed a bit surprised to learn that his $15,000 wedding would likely be worth a little over $30,000 today. I think 8% is a conservative number, but it works for this example. He then asked me where I came up with the 100k, since this is a far cry from $30,000.

The $30,000 represents the first doubling, we still have more to go. In reality we have a few decades before we can retire so a few more calculations will reveal:

First 9 years: 30k

Next 9 years: 60k

Next 9 years: 120k (Retirement Age)

The completion of the last 9 year block will place him at about the age of retirement, roughly. Considering this, the day he retires, he will be 120k behind because he withdrew funds from his IRA. This did not calculate the penalty and taxes they paid when they originally withdrew these funds.

So I can already hear what some of you are thinking, what if they borrowed this money instead of withdrawing it? That’s a fair question, however it is still not good news.

When people borrow from their IRA, the tank empties by whatever value they withdraw. Unless the borrower replaces the funds within the first year, they are now into year one of the situation described above. There are a few more considerations though.

Borrowing from your 401k means you are locked into your employer until this is paid back. If there is a job loss for whatever reason, they will call for repayment immediately, if you can’t come up with the cash, you will likely be on the hook for a 10% early withdrawal (If you are under 59 1/2) penalty, taxes, along with any other fee the institution may pose.

Repayment of your 401k loan will likely mean that you are not able to contribute to your retirement, as the investment funds will be going to loan repayment. Depending on the amount borrowed and the time needed to repay, this could last years. Translation: the borrower will not be able to contribute any funds toward retirement for several years. As we all know, the younger they are, the more detrimental this loss will be in the long run.

I think we can see that either way, a 401k withdrawal/loan, simply doesn’t pay.

 

 

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