Your 401(k) Loan Is Costing More Than You Think

One advantage of many tax-deferred 401(k) plans is the option to take out a loan against a portion of your vested balance. Although you may be able to take out a loan for a number of reasons depending on your plan, deciding to do so should really be an ultimate last resort. Research has shown that borrowing from a retirement plan tends to have a lasting impact – most accounts never get back to their projected pre-loan balance at retirement.

Common provisions of 401(k) plan loans. Many 401(k) plans offer loan provisions for a portion of a participant's vested balance. Contributions that individuals make to their own accounts are always vested, meaning they are always available and cannot be taken away should you leave your job. Depending on your specific employer's policies, the portion that your employer contributes to your account may be vested over time, and may not be available when you decide to take out a loan. While the law allows all 401(k) plans to offer loans to participants, companies can choose whether they want to offer loans or not. Some small businesses cannot afford to give a loan provision.

The amount you may be able to borrow will in part depend on your vested balance. While individual plans may differ, the general guidelines for 401(k) loan amounts are as follows: 401(k) account holders may borrow the greater of $10,000, or 50 percent of their vested balance, up to a maximum of $50,000. Loans must be repaid within five years; although first-time homebuyers may be offered an extension.

Not free money. A common misconception about borrowing from a 401(k) plan is that it's an interest-free loan. Aside from the opportunity cost of missing years of tax-deferred compounding, 401(k) loans are not free; borrowers will need to repay the loan with interest. Granted, the interest rate is typically less than a conventional loan, but as we'll outline below, this is not the only cost of borrowing from your future.

The true cost of 401(k) loans. Studies have shown that using a 401(k) as an emergency savings reserve has a lifelong impact for most investors. Here's how:

According to a study by Fidelity that took place during 2007-2013, 40 percent of individuals who took out 401(k) loans reduced their savings rate from pre-loan levels within five years and 15 percent stopped saving altogether. Depending on the amount borrowed and your contribution rate, future paycheck reductions may only go towards paying back the loan.

401(k) plans and other qualified tax deferred retirement plans are advantageous because workers are able to reduce their current taxable income while their contributions grow tax-free until retirement. When you take out a loan from a 401(k), you not only lose out on that tax-deferred growth, but you also have to repay the loan with after-tax dollars. It will take you longer to repay your pre-tax loan with after-tax contributions. Further, you may end up paying more in taxes at the end of each year you're in repayment, as pre-tax contributions are likely much lower. Once you enter retirement and begin withdrawing funds, you'll pay tax for a second time on loan repayment dollars.
Even for accounts with no tax deferred growth, saving over a long period of time and with no withdrawals provides greater returns due to compounding. Compounding is when your savings earn interest, and then those earnings to generate their own earnings. Compounded growth is even more impactful in tax-deferred accounts.
One of the most critical aspects to consider before taking out a 401(k) loan is how stable your employment is. In most plans, if you quit, or if your position is terminated for any reason, you will be required to repay the entire loan balance within 60 days.

Tough choices. If you're considering taking out a loan from your 401(k), odds are you're currently weighing a number of tough choices. A 401(k) loan may seem like the best or only option, but there are usually alternatives.

Before taking a loan for educational costs, first consider whether there are other sources of funding available. For example, would you be better off financially to complete a degree more slowly if your employer will cover the costs? While taking out student loans isn't ideal – it could actually be a better choice than dipping into your retirement savings.

Those who take a 401(k) loan for a home purchase tend to put themselves in a more precarious financial situation than other borrowers as the loans are larger and the repayment period is longer. Fidelity's study revealed these borrowers typically didn't save enough to begin with, which makes it much harder to get back on track with a new mortgage and unexpected costs of being a homeowner. Before taking a loan from your 401(k) to buy a home, take an honest look at whether you can afford it. Coming up with a down payment is usually half the battle – the other half comes once you already own it.

Retirement may be decades away, but often that's the beauty of it for those who take advantage of it. When trying to achieve more immediate life goals, try not to lose sight of long-term needs in retirement. Your options today may not be ideal, but there is no loan for your retirement.

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