Why It Doesn’t Make Sense to Take a Loan from Your 401(k)

Cash crunches are difficult. When you need money right away or are turned down by lenders, you may feel as if your only option is to take out a loan from your 401(k). According to research from The Wharton School of the University of Pennsylvania, 20% of 401(k) plan holders borrow from their 401(k) plans at any given time. Researchers estimate that an average of 13,000 Americans take a loan each month out of their 401(k)s for a median of about $4,600. However, there are many reasons why taking a loan from your 401(k) is a bad idea.

The loan becomes due when employment ends at your current company

Qualified plans aren’t required to provide loans, but if they do, they can lend up to one-half of your vested account balance or a maximum of $50,000. When taking out a loan from your 401(k), you must pay back it back in full within five years, making at least quarterly payments that cover applicable charges for interest and principal. In very few instances, such as purchasing your principal residence or performing military service, a 401(k) loan can be paid in a period of more than five years.

However, when you are laid off, fired, or quit your job, the remaining balance of your loan becomes due within 60 days of the date of termination of employment. Given that the typical U.S. worker lasts 4.6 years on a job and that one-fifth of U.S. workers are laid off, there are good odds that you won’t have five full years to pay back that loan.

Your unpaid balance becomes taxable income

If you can’t pay back your loan within five years or 60 days after ending previous employment, then your remaining loan balance becomes taxable income. Not following your repayment schedule can also turn your 401(k) loan into a non-qualified distribution. In addition to paying applicable income taxes, including capital gains, those under age 59 1/2 are subject to a 10% early withdrawal penalty from the IRS. Certain states may charge additional income taxes and penalties. All of this would leave you with a large tax bill for that year’s tax return.

The unpaid balance can’t be rolled over

Unlike your remaining vested balance in your 401(k), an unpaid loan balance deemed as taxable income can’t be rolled over into a qualified plan with a new or existing employer or into a new or existing IRA. Given that every year you have a limit as to how much you can contribute to your 401(k), losing past contributions is a major blow to your nest egg. Not only you lose the current balance, but also you miss out on many years of investment returns.

Double the 401(k) tax payments

A key advantage of saving for retirement with a 401(k) is that you defer taxation on those funds until retirement when you’re more likely to be in a lower tax bracket. By taking out a loan from your nest egg, you’ll be paying that loan with after-tax dollars and paying again taxes upon retirement. Now, that’s a double whammy!

Additional 401(k) loan fees

The National Bureau of Economic Research (NBER) found that about 90% of 401(k) plans charge fees for loans. On top of an interest rate of prime plus 1% to 2%, you’re very likely to pay an origination fee and annual maintenance fee. According to the NBER, origination fees range from $25 to $100, with a median of $50, and maintenance fees can go up to $75, with a median of $25. Loan fees vary per plan, so contact your plan administrator for more details as you're assessing how much the total cost of your loan will be.

There are cheaper credit alternatives available

If all of the reasons above weren't enough to convince you against taking a loan from your 401(k), keep in mind that there any many other, much more cost-effective options.

Lower-cost alternatives:

  • Other types of loans (home equity line of credit)
  • Working with a non-profit credit counselling agency to establish lower interest rates with creditors

Comparing only the interest rates from a $1,000 loan through a financial institution to a $1,000 loan from your 401(k) isn’t apples to apples. When you consider the fees, interest charges, potential taxes in case of default, and foregone investment return, you’ll often find that true cost of a 401(k) loan is much higher than you’d expect.

Additionally, it turns out that if the interest rate on your loan is lower than the rate of return you’re earning on the holdings of your 401(k), the impact on your retirement savings is greater. You’ll miss out on even more potential growth. Let’s assume that you have a vested $50,000 balance in your 401(k) and you’re considering a $10,000 loan.

No 401(k) loan With 401(k) loan
Balance today $50,000 $40,000
+ Investment return (8%) +$4,000 +$3,200
- Loan repayment N/A -$10,000
- Interest paid on loan (5.50%) N/A -$550
= Balance one year from today $54,000 $53,750

In this scenario, you would miss out on $250 of investment returns in one year (and this is assuming you pay back the loan in the same year). You'll also be missing out on additional returns in the years to come because of a lower balance.

Tendency to create a bad habit

One dip into your 401(k) can quickly turn into another...and another! In a one-year study of 180,000 borrowers from 401(k) plans, 25% of them took out a third or fourth loan, and 20% of them took out five or more loans.

In sum, taking a loan from your 401(k) doesn’t make sense and we recommend against it. Applicable fees, foregone investment returns, and potential tax penalties can all add up to cause major damage to your nest egg. And even worse, create a spiral of additional debt.

Image credit: Flickr

If you want to set up or switch to an a 401(k) that's great for employees and employers, let your company know about Captain401.