Published:

04/17/2013 12:19pm

401(k) Loans: Quick Cash with Dire Consequences

A 401(k) loan can be tempting in today's economy, but before you tap into your 401(k) for an “easy loan,” you should understand the disadvantages of these transactions and the long-term effect it has on your Paychecks for Life.®

PROS
Borrowing from 401(k) accounts is extremely easy these days, and an increasing number of participants are taking out 401(k) loans. These loans offer some attractive benefits for those in need of quick cash:
• Loan Terms: Participants can borrow 50 percent of their vested retirement account balance, up to $50,000.
• Interest: Their interest rate is typically a low rate of prime plus one or two percent.
• Convenience: Participants pay themselves back via payroll deduction directly to their 401(k) account.
• Term: Borrowers have between one to five years to pay off the loan.
• Additional Cost: Generally, there is an added one-time fee of $125 or so.

Most 401(k) providers make it easy for participants to calculate the loan pay off amount and the monthly cost by going online. With just the click of a button, a loan check can be on its way. All of this may sound attractive, especially if participants are staring at a credit balance with a 20 percent interest rate. Considering all of these factors, taking a loan from a 401(k) at five percent interest and paying it back over five years seems to make sense. However, there are many risks associated with these loans that need to be seriously considered.

CONS
While taking 401(k) loans may seem beneficial, there are far more disadvantages and substantial short and long term expenses:
• Cost of Default: If borrowers become disabled or leave their jobs, they must repay the loan in 60 days. Failure to do so results in the balances being treated as distributions. They will owe taxes (25 percent or more) plus 10 percent penalties on the unpaid amount (if they are under age 59 ½).
• Failure to Make Payments: If participants fail to make monthly payments after 90 days, the loans will default and the same taxes and penalties will apply.
• Cost of Loan Repayments: The real cost to repay the loan is not just the interest rate, it's the tax cost as well. When contributing money into their 401(k), participants do so with pre-tax dollars. When they pay back a loan, it is with after-tax dollars. If they are in a 25 percent tax bracket, every dollar only gives them $0.75 toward repaying their loans, which will be taxed again when withdrawn at retirement. While the loan interest rate is low, the cost of repayment can be 35 to 50 percent, far worse than any credit interest they may be paying.
• Significant Reduction in the Retirement Savings: This is by far the greatest hazard to taking 401(k) loans, and it is the one most participants fail to understand and calculate. When participants take loans from their retirement accounts, they are essentially robbing themselves from their Paychecks for Life.® In addition, when participants take loans, many companies do not allow them to continue to contribute to their 401(k)s. Oftentimes, participants stop making their contributions because they can't afford to make both their loan payments and their regular contributions. This only compounds the negative impact of 401(k) loans. Let's look at an example:

Mary is 35 years old. Her income is $40,000. She has $20,000 in her 401(k). She is contributing six percent (or $2,400) per year, and her employer matches three percent. Assuming she can earn eight percent on her 401(k), she would have $583,723 at age 65. However, Mary decides to borrow $10,000 from her 401(k). She can no longer make her six percent contribution while paying back the loan each month, so she stops contributing. She not only loses the compounding interest on her six percent contribution each year, she also forfeits her employers three percent match (effectively giving up a 50 percent guaranteed return on her money). Now at age 65, she will only have $456,673 (or a loss of $127,000).

While taking a loan from a 401(k) may appear easy and inexpensive, it usually is t