Should lawyers borrow from their 401(k) to payoff student loans?

It’s no secret that most young attorneys’ #1 financial roadblock is a mountain of student loans. There are many creative solutions I implement for my attorney clients to mitigate this burden, but borrowing from a 401(k) is rarely the optimal solution.

Why borrowing from a 401(k) might seem like a good option

Most 401(k) plans allow plan participants to take a loan against the balance of their account. Moreover, the interest rates on these loans are often quite favorable (mostly around 4%).

So, if your student loans carry an interest rate that’s higher than 4%, why not take advantage of the arbitrage opportunity to borrow at the lower rate to pay off the loan with the higher rate?

The hidden cost of the 401(k) loan

Unfortunately, the interest rate on the loan is not the only cost you incur when you borrow from your 401(k). The larger, often over-looked cost is the opportunity cost of not keeping this money invested in the market.

In other words, when you take a loan from your 401(k) the money borrowed is no longer invested and therefore will not earn a rate of return for you.

For example, if you expect an average market rate of return of 5% (fairly conservative) plus an interest rate of around 4%, it becomes more evident that it’s actually a very expensive loan.

Other important considerations

• You also lose out on tax-efficiency because loan payments are made with after-tax dollars.
• Your 401(k) contributions become loan repayments so you lose out on any company match.
• Employees who leave their jobs, are laid off or fired typically have to repay their loan within 60 days. If they don’t, the loan amount is considered a distribution, subjected to income tax and a 10% penalty if the borrower is under 59 and a half.

Bottom line - as the saying goes, if it seems too good to be true it often is!

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