07 Dec Using a 401(k) loan to fund college

Q. I need money to pay for college. I don’t own a home but I can borrow from my 401(k), which has a better interest rate than personal loans that I’m seeing. What do you think?
— College poor

A. We hate the idea of pulling money from a retirement account for any goal other than retirement.

That’s because you’ve been working hard to fund your 401(k), and you’re hopefully getting a match from your employer.

“For most folks this is one of their main sources of retirement and it could be a serious miscalculation to raid it for a non-retirement related goal,” said Jeff Rossi, a certified financial planner with Peak Wealth Advisors in Holmdel.

There are lots of what ifs and caveats to consider, and even though it makes us cringe, it’s possible a 401(k) loan could be a better option for you.

Rossi said taking a 401(k) loan to fund education comes down to a cost-benefit calculation.

The question is: Will the amount you lose due to having your retirement assets out of the market gain you something more in terms of the financial impact from your degree, or for your child’s degree, depending on who this is for?

Rossi said it’s a bit of an intangible because no one really knows if their kid’s history degree is going to allow them to do better financially compared to not going to school at all. Chances are the answer is yes, but how much better?

He said a better calculation is to just look at the potential rate of return of the assets you intend to take out of the market, the interest rates you’ll pay back to your 401(k) if you took a loan, and the interest rates for a personal loan.

When you take a 401(k) loan, you lose the opportunity to get market returns on that money, Rossi said. So for example, let’s say you have $100,000 in the account. If the market returns 10 percent, at the end of the year, you’ll have $110,000.

If you borrowed $10,000 and would up paying it back during the year at a 7 percent interest rate, your situation would be:
Balance $90,000
+ Market Return $9,000 (10% x $90,000)
+ Loan Repayment $10,000
+ Loan Interest $700 (7% x $10,000)
= New Account Value $109,700

“By taking and re-paying the loan, you wind up with less at the end of the year due to the opportunity cost of having money out of the market, plus you paid $700 out of your own pocket,” Rossi said. “If you do that with bigger numbers over a longer term, the amounts can be significant.”

He said the higher the rate of your 401(k) loan, the less the loss of opportunity will be because you’re putting more money back into the market due to a higher interest rate.

If you pursue a personal loan, that’s pretty straightforward.

“If you can get a loan rate less than the expected rate of return of your assets, you’re better off taking the loan,” Rossi said. “And if it’s a student loan where you can deduct the interest, it works in your favor even more.”

Of course, the future rate of return of your 401(k) assets is yet to be determined, but if you forecast a conservative number and compare it to the loan interest rates — the 401(k) loan and the personal loan — you can get a good idea which strategy makes the most sense financially, he said.

Now, those caveats.

“The biggest one is if you borrow money from your 401(k) and then leave or get terminated from your job, that loan will typically need to be repaid immediately, otherwise it will be considered a distribution subject to income tax and a 10 percent penalty if you’re younger than 59 ½ and not retired,” Rossi said. “If there’s any possibility that your job isn’t secure, I’d think twice about taking a loan from your 401(k).”

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This story was first posted in December 2015.