Is it a good idea to borrow from your 401(k)? Apparently, a lot of people are doing it. Fidelity, a custodian of 29 percent of the $2.6 trillion held in 401(k) accounts nationwide, recently released a report showing that employees have increased the amount of money they’ve borrowed from their 401(k) accounts over the past year.
A spokesman for Fidelity stated that the increase was mainly due to the tough economic times. The spokesman noted that a similar increase in borrowing occurred during the recession of 2001-2002.
You can borrow from your 401(k) account for almost any reason as long as your employer permits plan loans. Loans have to be repaid within five years (unless the loan is to buy a principal residence) through payroll deduction. The maximum loan is 50 percent of your account balance up to $50,000 and you can only have one loan outstanding at a time.
You Can, but Should You?
But, is it a good idea to borrow from your 401(k)? There is a lot less paperwork for plan loans and you don’t have to worry about your credit score. The rates are usually much lower than conventional loans. Many even argue that the rate doesn’t matter because you are really just paying yourself interest.
This is a myth.
When you borrow money from your 401(k) account, the custodian moves the amount of assets securing your loan to the “safe” option in your plan. That is typically the money-market fund. The interest rate on money-market funds today is well below one percent (probably much closer to zero). One of the hidden costs of borrowing from your 401(k) is the opportunity cost that is lost on those funds. The plan provider then loans you the money at prevailing rates. Recent surveys show these loans are usually being issued at prime plus one percent. This interest is paid to the plan provider. You are not really “paying yourself interest,” but rather paying interest to the plan provider to borrow your own money.
The loss of earnings potential can be significant, especially if you borrow during a down market. The custodian moves your money out of stock funds to secure the loan, which locks in a low share value. These shares are replaced at higher share values as the loan is repaid. This could add another five- to 10-percent cost to the loan on top of the interest charged.
How would you feel about paying taxes twice on the same income? According to a recent article in Investor’s Business Daily, the repayment of the loan is another tax trap. Contributions to your 401(k) are made with pre-tax dollars. One of the big advantages of saving in a 401(k) account is the ability to save the money before you pay taxes on it. The contributions and the earnings all grow tax-deferred until you withdraw them in retirement. Theoretically, you will be in a lower tax bracket when you retire and will pay a lower tax rate than you did while you were working. However, the loan payments are made with after-tax dollars that will be taxed again when you withdraw them in retirement. This amounts to a form of double taxation that also adds to the cost of your loan.
401(k) Loans Can Be Tax Traps
Another tax trap can occur when the loan is repaid. If you miss the five-year deadline, the outstanding amount is considered a withdrawal. Withdrawals are subject to tax at ordinary income-tax rates. The amount considered a withdrawal is also subject to a 10-percent early withdrawal penalty if you’re not 59-1/2 years old when the withdrawal occurs.
The loan has to be repaid through payroll deduction. What if you leave your job or get laid off? Most plans give you 60 to 90 days to pay off the loan in full once you are no longer employed. Paying off a loan is usually not a top priority when you lose your job. Any balance not repaid will be considered a withdrawal, and subject to income taxes and possible penalties.
You Might Stop Making New Contributions to Your 401(k)
Finally, many employees who take loans stop making contributions until the loan is repaid. The missed contributions are rarely made up and the loss of matching contributions can never be recovered. The impact on your retirement plans could be significant.
Consider the cost of a $50,000 loan that is repaid over five years. The funds held for securing the loan earn one percent. The funds are replaced into a balanced allocation as they are repaid with an average return of seven percent.* The funds would grow to $60,000 when the loan is repaid. Had the money remained in the balanced allocation for the entire period, it would have grown to $85,000. The interest on the loan payments at the current prime plus one percent would total $5,400 over the period. Total cost of the loan (opportunity cost plus interest) would be $30,400. This is a very steep price to pay for a $50,000 five-year loan.
The price tag increases when you consider the cost to your retirement. Because of the loan, you now have $60,000 in your retirement account instead of $85,000. The lost $25,000 will mean a reduction of $100,000 over 20 years!
Borrowing from your 401(k) should be a last resort. Saving for retirement is a priority because the longer the money is left to grow your 401(k), the easier it will be to reach your goal. You can avoid needing to borrow your retirement funds by building up your after-tax savings. Always keep adequate funds on-hand to meet emergency spending needs. This will require careful budgeting and discipline. I suggest reading my September 2010 column, Five Keys to Financial Success. The first key is to live below your means. Master this key and you won’t find yourself tempted to borrow from your retirement.
* This is a hypothetical example and meant for illustrative purposes only. Rates of return are not guaranteed. The information provided is general and educational in nature; it is not intended to be and should not be construed as investment, legal or tax advice. Past performance is not indicative of future results. All investments carry the risk of loss, including loss of principal.
This article originally appeared in Lancaster County magazine.