The Dilemma
The number of times I hear, “Taking a 401k loan is a great idea. You pay yourself back in interest!” is astounding and makes me want to dive into a full-on rant … so here I go.
One option to access cash in a pinch, fund a housing project, or cover DraftKings gambling losses is through a 401k loan. Whatever the case may be, I get many questions about these loans. Not every plan allows for it, but if yours does, be aware that the convenience of taking such a loan comes with significant consequences.
The Issues
The obvious costs are the ones that show up on your account statement including:
- Origination fees (typically $50 – $100)
- Loan maintenance fees (typically $25 – $50)
- Interest charges (typically prime + 1-2%)
Right off the bat, you could be charged $150 dollars in origination and maintenance fees. Thus, these costs have a greater impact on smaller loans. For example, if you take a $1,000 loan, it could immediately cost you 15% of the total balance.
Additionally, you owe interest to yourself, which is currently around 9.5% – 10.5%. In my opinion, this isn’t a major issue since the interest is credited toward your account balance.
However, you need to be aware of the less apparent fees.
The ambiguous (and potentially larger) expenses include opportunity costs, potential of defaulting, and taxes.
The opportunity cost represents the potential investment gains you miss out on. When you take a loan, the borrowed money is no longer invested. For example, if you took a $50,000 loan and paid it back over five years while the market returned 10% per year, you’d miss out on $30,525 in gains. However, if the market goes down, you would actually benefit from it.
If you have to leave your job for any reason, you are responsible for paying the loan back by year end. If you fail to pay it back, you would default on your loan and be subject to taxes and likely a 10% penalty. To avoid taxes and penalties, you could rollover the remaining loan balance into an IRA.
Keep in mind, 86% of loans that go into default happen when people leave their job.
Loans are subject to double taxation. If your contributions are pre-tax, you first pay tax on your loan repayments and again on your distributions. If your contributions are Roth, you first pay tax on your contributions and again on your repayments. Either way, you are taxed twice! Uncle Sam sure likes this trickledown effect, and most don’t take it into account.
Alternative Solutions
Let me provide you with some alternatives that may make more sense. Keep in mind, these are just a few suggestions and are not actual financial advice. Please consult with your advisor before making any decisions.
- Start an Emergency Fund
- Save between 3-6 months of expenses
- Consider using a high yield savings account (HYSA)
- Open a 0% APR Credit Card
- Find a card that allows you make purchase for 12 months with no interest fees
- Make sure it doesn’t have an annual charge
- Get a Personal Loan
- Interest rates are typically high, but it’s a fast way to get cash
- Pay off as soon as possible, due to high interest rates
- Use a Line of Credit
- You can use your home (HELOC) or a broker account (SBLOC)
- Both have an option for interest-only payments
- The interest rate will change based on market conditions
- Withdraw Roth IRA Contributions
- Not an ideal option, but you can withdraw contributions tax & penalty-free
- Will have an effect on retirement cash flow
The Conclusion
While 401(k) loans may seem convenient, they come with numerous costs and risks. From the upfront fees and interest charges to the significant opportunity costs and potential taxes & penalties, the true expense of borrowing from your retirement savings can be substantial.
Before borrowing from your 401(k), evaluate your options. Each alternative has its own set of pros and cons, so it’s important to weigh these carefully and talk with a financial professional.
Ultimately, I believe protecting your retirement savings should be a priority. Understanding the costs and risks of a 401(k) loan can help you make choices that align with your financial goals.
Sources:
https://www.lendingtree.com/personal/401k-loan/#:~:text=Retirement%20plans%20typically%20charge%20the,but%20with%20post%2Dtax%20funds
https://www.forbes.com/advisor/retirement/best-401k-loan-alternatives
For our newsletter disclosure, click here.