If you have a sizeable balance in your tax deferred 401, 403, IRA, Keogh, or other tax free account, it can be tempting to borrow against the account for hardship, medical, education, or the purchase of a home. There are times when a loan makes good financial sense. However, most of the time it is best to leave your funds in the account to take advantage of the tax free compounding (click here to read a previous series that covers compounding in detail). This article will go over the “cost” involved with borrowing against one of these accounts.
Revisiting the effect of compounding
If you read the previous series on compounding interest, you understand the enormous benefit compounding brings to multiplying your final account balance after many years. Most advisors recommend you invest in a combination of stocks and bonds to spread the risk and still participate in the higher historical return stocks provide.
Costs of borrowing funds
When you borrow from your account, the borrowed funds are usually paid back at the lowest rate – usually the bond rate (approximately 4%). In that case, you lose out on the significant long term gains that would have been achieved from a higher compounding rate closer to the historical stock gains of 8%. However, another “penalty” that many people are not aware of is that funds used to pay back the loan are after tax money. You can’t deduct the money used to pay off the loan. Therefore, you are using money that has already been taxed to pay back the loan. The money you paid in taxes could have also benefited from compounding interest over time. So, you lose two ways – the higher compounding the funds could have received if left in the account and the compounding of the taxed dollars spent to pay back the loan. There is also the potential for a third penalty if the borrower decides to lower the ongoing regular investment into the account in order to afford the new loan payments. In this case, there is additional loss of compounding growth against the reduced contributions over time. Lets look at an example to help illustrate the issues involved with borrowing.
Simplified example of borrowing from a tax deferred account
Assumptions: 1) Joe has $75,000 in his account earning a long term average annual return of 6% and is contributing $1,000 monthly; 2) He borrows $25,000 (for whatever reason) from his tax deferred account; 3) The current bond rate is 4% and that the loan will be paid back over 15 years at this 4% rate with a monthly payment of $184.92; 4) Joe pays a combined State and Federal tax of 30%.
Had Joe had continued his investment plan of $1,000 monthly and not taken out a loan, he would have a ending balance of $474,876 in 15 years. By removing $25,000 as a loan, the remaining $50,000 balance with the $1,000 monthly contributions would grow to $413,523 after 15 years or $61,353 less ($474,876 – $413,523). However, the $25,000 would add back a 4% compounding return into the account over the 15 years of $8,286 as the loan is paid back. This lessens the difference to $53,027 ($61,353 – $8,286).
Adding real life complexity to the example
That was a very simplified example since the 4% loan payments would actually be added back into the same investment split that the new contributions are distributed across – bonds, stocks, etc. So, if the account is earning a 6% average return from the current investment split, then each payment would compound at this 6% rate through the remaining years. This would lessen the $53,027 difference. Another complexity is the 4% loan is paid back with after tax dollars. Since the combined tax rate is 30%, then it takes $1.30 of before tax funds for every $1.00 paid toward the loan. Since the monthly payment on the 4% $25,000 loan is $184.92, then approximately $55 is paid each month in taxes (185 dollars x 30 cents taxes on each dollar equates to $55 in taxes). If there was no loan, then this $55 could have been invested monthly into the tax deferred account at the average 6% rate to earn $15,995 after 15 years. This is an added loss on top of the $53,027 difference calculated earlier.
You need to see a qualified financial advisor to look at your particular situation. Information provided above are hypothetical and not meant to be financial advice for any specific situation. However, as you can see, there are many variables that could affect the calculations. But, in all cases you end up with less in your tax deferred account over the long term by borrowing funds that by not borrowing. Again, there are situations where loans may make sense, but you need to be aware of the long term consequences of missing out on compounding over time for the funds borrowed from the tax deferred account. A financial advisor is usually going to be much cheaper than the amount of money you may lose over time by borrowing.
Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.