When it comes to paying for big ticket items, we often borrow. In this article we focus on two loan sources: borrowing from your 401(k) retirement plan, and borrowing against your life insurance policy with a policy loan.
Which is better: 401(k) loans or life insurance loans?
You’ll find conflicting advice. Some experts say 401(k) loans should be your first choice. Others, like Forbes contributor Colleen Oakley, say 401(k) loans should be your last choice.
The Championship Match: 401(k) Plan Loans vs. Life Insurance Policy Loans
To settle this once and for all, I’m going to climb into the ring with Rich White, the former editor of Financial Planning magazine, and a 401(k) loan proponent. We’re going to duke it out head-to-head in an imaginary six-round championship fight.
Round 1: How Do 401(k) Loans Compare to Life Insurance Loans?
Rich White: Okay, Pamela Yellen. Prepare to get slaughtered. For starters, 401(k) plan loans are easy to get!
Here’s the process for getting a 401(k) loan from one of the nation’s leading retirement plan providers for business, Creative Retirement Systems. Look how simple it is! No credit check, no bank approval required.
The entire process is just 13 “easy” steps:
- Get the six-page application from human resources
- In the application, tell the company how much you need
- Explain in detail why you need the money
- Select one of the mandatory repayment schedules
- Have your spouse sign the permission form
- Get a notary public to notarize your spouse’s signature
- Sign a promissory note
- Sign an irrevocable pledge and assignment of assets agreement
- Send the application package to the company
- The company loan committee will review your application
- If the committee decides to give you the loan, the company will send you a check
- They will also send you a payment schedule, a schedule of fees, and they’ll tell you what the penalties can be if you don’t make your payments as agreed
- You should have your money in two weeks or less
Pamela Yellen: Are you kidding me? With a life insurance loan, you just call or send an email to the life insurance company and tell them how much money you want and where you want them to send it. You’ll typically have the money in your account or a check in the mail in three or four days, not weeks.
And there are no government-imposed limits on how much you can borrow or what you can use the money for.
Yellen: Here’s the beauty of life insurance policy loans, in the words of David Shelton, a healthcare vice president in Texas, from The Bank On Yourself Revolution, page 104:
I didn’t want to have to ask for permission to use my own money. I had very limited control of my money in my 401(k). I couldn’t put in as much as I wanted, and I needed permission to borrow my own money if necessary. Bank On Yourself gives me control over my money. We’re also using Bank On Yourself life insurance policy loans to pay for our two sons’ private school education in one installment to take advantage of a discount.”
Yellen: With policy loans from the life insurance companies preferred by Bank On Yourself Authorized Advisors, you decide if and when to repay the loan. It’s your schedule. Your Bank On Yourself advisor can help you with tips to make sure you don’t let the loan get out of hand. But if you have a down month or two, or six, you can skip a few payments. And there are no taxes, penalties, or fees for doing that.
White: I still say that if you’re borrowing less than $50,000 and can pay it back in a year or less, borrow against your 401(k) because this can be the quickest, simplest, lowest-cost way to get the cash you need. Receiving a loan is not a taxable event, and it has no impact on your credit rating. Assuming you make your loan payments on schedule, your loan probably won’t affect your account’s growth.
Yellen: A life insurance policy loan isn’t a taxable event either, and there’s no impact on your credit rating. Your loan absolutely will not affect your account’s growth (assuming it’s from one of a handful of life insurance companies that offers this feature), even if you don’t make your payments when you thought you would.
Besides, Rich, your $50,000-paid-back-over-one-year scenario isn’t very realistic. At 4% interest (a typical 401(k) plan loan rate), you’d have to pay back almost $4,300 per month. And assuming you could make those payments without a hitch is a pretty risky assumption.
And it’s silly to say a 401(k) plan loan probably won’t affect your fund’s performance! If the market goes up while your money is out of the account, of course you lose!
White: Yes, but if the market goes down, I’ll avoid the loss.
Yellen: Is that why you’re in the market in the first place—in the hopes that you’ll be sitting on the sidelines during a market pull-back?
Yellen: Besides, with 401(k) plan loans, there are government-imposed limits on how much you can borrow, how long you can borrow it for, and how often and in what amounts you must pay it back.
White: But those Internal Revenue Service rules are there to protect you, to make sure you have money for retirement. The IRS is your friend, you know.
There’s the bell!—Who won Round 1?
Round 2: What Are Repayment Requirements for a 401(k) Loan?
Yellen: Another thing. You can only borrow $50,000 from your 401(k) plan if your account balance is greater than $100,000. You’re limited to 50% of your balance.
White: But 401(k) loans give you repayment flexibility. Sure, you have a mandatory repayment schedule you have to agree to, but they let you pay off your loan faster than that, with no prepayment penalty.
Yellen: Big whoop! What happens if you can’t pay as fast as you planned?
White: Well, if you don’t make a payment for 90 days, the money is considered a distribution and it’s taxed as income, plus you’ll have to pay a 10% penalty if you’re under 59½. That’s all.
Yellen: Oh. So if I borrow $50,000 and something dreadful happens, 90 days later I’m hit with a $5,000 penalty, plus an income tax bill of $12,500 (assuming I’m somehow still in a 25% tax bracket, even with that $50,000 bump in income!)—for a total of $17,500 due next April 15? Is that what you mean by repayment flexibility?
White: Well, if you look at it that way …
There’s the bell!—Who won Round 2?
Round 3: What Are the Costs of 401(k) Plan Loans Compared to Life Insurance Policy Loans?
White: There’s no cost for a 401(k) plan loan, other than perhaps a small administration fee.
Yellen: Really? Just a small administration fee? Fidelity Investments charges $50 just to set up the loan. (Some other companies charge more). And if you need your money faster than snail mail, Fidelity will send it to you overnight—for a $25 fee.
That totals up to a whopping 15% in fees on a $500 loan!
White: Maybe you should borrow more than $500, so the percentage will be less?
Yellen: Get real! If someone steals $75 out of your wallet, do you just brush it off? Plus, many plans charge an ongoing administration fee for every year your loan is outstanding!
And that’s not all.
The New York Times reports a study that shows how much your 401(k) plan value can be reduced by taking loans: a thirty-five-year-old with a $20,000 plan balance who takes out two 401(k) loans in fifteen years ends up with about $38,000 less at age sixty-five than someone who never borrows, even if the loans are repaid without penalty.
White: But that guy took out two loans. That’s a bit excessive, don’t you think?
Yellen: Not at all! What about the Bank On Yourself policy holders who take out multiple life insurance loans to finance vacations, cars, RVs, pay for college, business expansion, and who-knows-what-else? They may have a dozen or more loans between age 35 and 65, with their cash value growth not slowing down by even one penny!
White: Oh my gosh! I didn’t know you could do that.
Yellen: And what if I want to pay back that $50,000 401(k) plan loan in regular payments over six years? I can’t do that, can I?
White: Well, no. Not actually. Government regulations specify a maximum five-year amortizing repayment schedule for 401(k) loans, though the repayment schedule may be extended if you’re using the money for a down payment on a home.
Yellen: So if I want to borrow $40,000 to help finance my child’s college education, I’ve got to pay it back in five years?
White: Well … yes, but how much time do they give you to pay back a $40,000 life insurance policy loan?
Yellen: As much time as you need!
White: No way!—Really?
Yellen: Besides, some 401(k) plans won’t let you make any contributions while making loan payments. Others make you wait a set time before contributing again after taking a withdrawal. If your employer matches contributions, you’ll be taking a double hit.
White: Yes, but …
There’s the bell!—Who won Round 3?
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Round 4: What if You Lose Your Job and You Have a 401(k) Loan?
Yellen: You’re a nice guy, Rich, but surely you know that disaster is just waiting to strike if someone has a 401(k) loan and they change jobs, get fired, or otherwise lose their job. If you leave your company for any reason and you haven’t reached the magic age of 59½, in most cases you’re required to pay your loan back in full with interest in thirty to sixty days, or you’ll have to pay income taxes on the money you borrowed plus a 10% penalty.
White: Well, those are the rules.
Yellen: And those rules can spell disaster.
Look: In boxing, they are very strict. You can’t hit someone who’s down. But there’s no such rule when it comes to 401(k) loans. When people get downsized, they’re in a very vulnerable position. No income. No job. Maybe no prospects of a job for months or longer!
Now tell them they must pay back that 401(k) loan—with interest—in the next two months, or pay income tax on the loan and a 10% penalty. And they have no income. What does the IRS do to someone in that kind of situation?
White: I really don’t want to think about it. Can we talk about something else?
Yellen: Sure, we can talk about something else. Let’s talk about all the people who love being their own banker! Rich, check out these posts from people who are thrilled with their Bank On Yourself life insurance policy loans. Then come back and meet me here for Round 5!
There’s the bell!—Who won Round 4?
Round 5: What Happens if You Default on a 401(k) Loan?
Yellen: Okay, Rich, we can talk about something else. Answer me this: what happens if someone defaults on a 401(k) loan?
White: Well, we always recommend that you don’t default on your loan. You shouldn’t take out a 401(k) loan unless you have enough in reserve—
Yellen: Huh? Only take out a 401(k) plan loan if you have enough money on hand so you don’t need the loan?
White: Well, that’s the safest thing.
Yellen: In my latest New York Times best-selling book, The Bank On Yourself Revolution, I tell about the Harvard University economist who estimates that 15% of 401(k) loan balances go into default, and at least 75% of workers who leave their jobs with a loan outstanding end up defaulting and getting stuck paying penalties and taxes.
White: Gee, is it really that bad?
Yellen: Yes, it really is that bad.
White: But don’t you see, if they only took out a 401(k) loan when they had enough in reserve to pay back the loan in an emergency, they wouldn’t have that trouble.
Yellen: Right. And don’t you see that if they had that much money, they wouldn’t need a 401(k) loan in the first place?
There’s the bell!—Who won Round 5?
Round 6: Advantages of Life Insurance Policy Loans
Yellen: This is the last round, so I’m not going to pull any punches.
With life insurance policy loans, such as from Bank On Yourself-type policies, you have complete control over the equity (cash value) in your policy. You can borrow your equity whenever you want, for whatever you want, with no government restrictions. There are no penalties for early withdrawals, late withdrawals, or no withdrawals.
With Bank On Yourself-type policy loans, you have full access to 85% or more of the cash value of your policy beginning the very first month, without selling your assets to do it.
In fact—and this is one of the hardest things for people to grasp—if your policy is administered by one of the handful of companies that offer this feature, when you borrow money, your policy can continue growing, just as if you hadn’t touched a dime of it.
Here’s the skinny on life insurance policy loans: With a Bank On Yourself–type policy, you can literally get your hands on the money you need from your account within days. You aren’t selling off assets. Your money is still growing like you never touched it. You aren’t running afoul of government regulations. And you aren’t subject to penalties.
It still really is your money.
What do you say to that, Rich White?
Referee: Um, I think you just knocked him out! … Wait! He’s saying something! What is it, Rich?
White: How can I get a Bank On Yourself-type policy?
Referee (holding Pamela’s hand high): What would you like to say in your victory speech, Pamela Yellen?
Yellen: I’ll just quote my favorite professor of economics, Robert Shiller of Yale University:
Errors of human judgment can infect even the smartest people, thanks to overconfidence, lack of attention to details, and excessive trust in the judgments of others, stemming from a failure to understand that others are not making independent judgments, but are themselves following still others—the blind leading the blind.”