The Pitfalls of 401(k) Borrowing
Maybe you’ve racked up credit card debt at a high interest rate, or need a little extra cash to buy a car. If you’re thinking about borrowing from your 401k to pay off these expenses, think again.
Many plans allow participants to borrow up to 50 percent of their account balance, and return the money over five years with interest. In 2005, about one in five workers had outstanding loans, with the average unpaid balance at about $7,000, according to the Employee Benefits Research Institute (EBRI). But the transaction has hidden costs and big risks.
Let’s take an example. Your car breaks down, and you need $20,000 to buy another one. You can get dealer financing for 8 percent or borrow from your 401(k) at 5 percent. The 401(k) loan seems to make sense – it’s cheaper, and you’re paying the interest back to yourself. Here are the risks:
Risk 1: You get laid off. You would have to repay the loan quickly (typically in 60 to 90 days), or the government would consider it a distribution and (if you’re under age 59-1/2) slap you with a 10 percent penalty, as well as income taxes. Assuming you are in the 25 percent tax bracket, that’s 35 percent of the loan amount vaporized. So your $20,000 would become $13,000.
Risk 2: You get double taxed. Let’s say you are able to scrimp together $5,000 to buy the car. You borrow the other $15,000 from your 401(k) at 5 percent interest, and pay it off over five years. You’ll pay back $16,984 in principal and interest. But you had to pay the interest — $1,984 — from after-tax dollars, and you’ll pay income tax again on that amount when you withdraw it in retirement.
Risk 3: The so-called “lost opportunity cost” of 401(k) borrowing. The money you borrow doesn’t earn the tax-free interest it otherwise would. Figure in compounding and it can add up to a significant loss. Consider this example from Wisconsin-based financial planner Kevin McKinley: “A 25-year-old worker takes a $10,000 loan from the plan, loses his job and can’t pay it back. At 65, that amount would have been worth $678,000, at a 10 percent annual rate of return. He lost not just the loan amount — the $10,000 — but $5,000 in taxes and penalties he had to pay too.”
A 401(k) should be a lender of last resort. In an emergency, evaluate alternatives that will give you a lower after-tax cost of borrowing. That might include tapping a home equity line of credit, generic bank financing, or even family members. Start thinking of your 401(k) as a piggy bank, and you may find yourself working a lot longer than you planned.
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