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The hidden dangers of 401(k) loans

1. You might reduce your retirement contributions

If you're making a monthly payment on your 401(k) plan to pay back the loan, you may reduce your contributions to the plan itself.

For example, if money is tight — and that’s usually the reason why you'd be looking to borrow in the first place — you might reduce your payroll contributions into your retirement plan in order to free up more of your paycheck to cover the loan payment.

If you were contributing 10% of your paycheck to the 401(k) plan before you took the loan, you might reduce that to 6% or 7% so that you could be able to make loan payments without hurting your budget.

2. You may earn less in your plan on the amount of the loan

When you take a loan from your 401(k) plan, the interest you pay on the loan becomes the income you earn on that portion of your plan. Instead of earning stock market-level returns on your 401(k) plan investments, you instead “earn” the interest rate that you are paying on your loan.

That may not be anything close to an even match.

401(k) plan loan terms generally set the rate of interest on the loan at the prime rate plus one or two percentage points. Since the prime rate is currently 4%, if your plan trustee provides an interest charge of the prime rate plus 1%, the rate on your loan will be 5%.

Now, if we happen to be experiencing a particularly strong stock market — one that is consistently showing double-digit returns — that 5% return will look less than spectacular.

If you have a $40,000 401(k) plan and half of it is outstanding on loan to yourself, that money will be unavailable to earn higher returns in stocks. You might be earning, say, 12% on the unencumbered portion of your plan but only 5% on the loan amount.

The 7% reduction in the rate of return on the loan portion of your plan will cost your plan $1,400 per year. That’s the $20,000 loan amount outstanding, multiplied by 7%.

If you multiply that amount — even by declining amounts — over the loan term of five years, you could be losing several thousand dollars of investment returns in stocks on the loan portion of your plan.

If you often or always have a loan outstanding against your 401(k) plan, that lost revenue can total tens of thousands of dollars over several decades. You’ll miss that when retirement rolls around.

3. Taxes and penalties may apply if you leave your job

This is probably the biggest risk when taking a 401(k) loan. The loan must be repaid while you are still employed with your company. In this day and age, when so many workers change jobs so frequently, this is a major problem. Even if you roll your 401(k) over to a new employer, the loan with your previous employer must still be satisfied.

According to IRS regulations, if you leave your employer and you have an outstanding 401(k) loan, you must repay your loan within 60 days of termination. If you don’t, the full amount of the unpaid loan balance will be considered a distribution from your plan.

Once that happens, your employer will issue a 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) that reports the amount of the outstanding loan to both you and the IRS. You will be required to report the amount shown as a distribution from your retirement plan on your tax return.

Once you do, the unpaid loan amount will be fully taxable as ordinary income. Also, if you are under age 59 ½ at the time that the distribution occurs, you will also be assessed a 10% early withdrawal penalty tax. If you are in the 15% federal tax bracket and under 59 ½, you will have to pay 25% on the unpaid loan balance amount. You will also have to pay your state income tax rate on balance as well.

If your combined federal and state income tax rates — as well as the 10% penalty — total 30%, then you will have to pay a $6,000 total tax on an unpaid loan balance of $20,000. And most likely, you won’t have the proceeds from the loan available since they will have been used for other purposes. Worst of all, there are no exceptions to this rule.

4. A 401(k) loan may have loan fees

A 401(k) loan may require that you also pay an application fee and/or a maintenance fee for your loan. The application fee will be required to process the loan paperwork, while the maintenance fee is an annual fee charged by the plan trustee to administer the loan.

If your plan trustee charges an application fee of $50, and a $25 annual maintenance fee, you will have paid a total of $175 in fees over the five-year term of the loan. If the loan amount was $5,000, the total of those fees would be equal to 3.5% of the loan amount. That will also work to reduce the overall return on investment in your 401(k).

5. Using a 401(k) plan as an ATM

One of the biggest advantages of 401(k) loans is that they are easy to get. But it can also be one of the biggest disadvantages. Generally speaking, any type of cash that is easy to access will be used. That is, if you take one loan, you’ll take another. And then another.

All of the hidden dangers associated with 401(k) loans will be magnified if you become a serial borrower. That will mean that you will always have a loan outstanding against your plan, and it will be compromising the plan in all of the ways that we’re describing here.

It’s even possible that you can have 401(k) loan balances outstanding straight through to retirement. And when that happens, you will have permanently reduced the value of your plan.

6. Compromising the primary purpose of Your 401(k) for Non-Retirement Purposes

The ease and convenience of 401(k) loans have real potential to compromise your plan's real purpose, which is retirement, first and foremost. It’s important to remember that a 401(k) loan puts limitations on your plan. As described above, one is limiting your investment options and your investment returns as a result.

But an even bigger problem is the possibility that you will begin to see your 401(k) plan as something other than a retirement plan. If you get very comfortable using loans in order to cover short-term needs, the 401(k) can begin to look something more like a credit card or even a home-equity line of credit.

Should that happen, you may become less concerned with the plan's long-term value and performance — for retirement purposes — and give it a priority to the plan as a loan source. For example, since you can borrow no more than 50% of your plan's vested balance, to a maximum of $50,000, you may lose interest in building the balance of your plan much beyond $100,000. Instead, your contributions may become primarily aimed at repaying your loan(s) rather than increasing the balance of the plan.

It’s more of a psychological problem than anything else, but that’s the kind of thinking that could overtake you if you get too comfortable with borrowing from your plan.

401(k) loan costs

There are three costs associated with 401(k) loans:

1. Administrative fees

There is usually some sort of fee charged by the plan administrator to create the loan. It might be something like $100. If the loan amount is $10,000, you are paying a 1% origination fee for the privilege of getting the loan. The fee is usually withdrawn from your plan balance. This causes a slight but permanent reduction in the plan's value.

2. Interest

401(k) loans typically charge interest on the amount borrowed. The rate is usually one or two points above the prime rate, which is currently 4.75%. That would produce a rate of between 5.75% and 6.75%. That rate is lower than what you will pay for a loan from just about any other source. And on top of that, since the interest goes to your plan, you're basically paying interest to yourself. That seems like a good deal, at least until you consider the next 401(k) loan cost…

3. Opportunity cost

While the loan is outstanding and you're making interest payments on the amount borrowed, you're not receiving investment income on the unpaid balance. Even though the outstanding balance is receiving interest, you are the one paying it. You are still losing the “free” income from being invested. For that reason, a 401(k) loan is not a good deal from an investment standpoint.

The advantages of 401(k) loans

401(k) loans provide many advantages compared to other types of loans. That is a big part of the reason 401(k) loans are so popular.

These advantages include:

  1. No lender qualifying. You must qualify with virtually every other type of loan based on your income, employment stability, credit history, credit score, and sometimes certain assets. With 401(k) loans, you qualify based just on the fact that the plan sponsor employs you, and you have sufficient equity in your plan to support the loan requested.
  2. No “outside” payment to make. As discussed earlier, repayment is handled strictly through payroll deduction. You don't need to write a check and mail it to a third-party servicer or set up an automatic draft from your bank account.
  3. Paying interest to yourself. As noted earlier, you're paying interest back into your own 401(k) plan. That means you're not paying it to the lender, after which it's gone forever.
  4. No taxes or early withdrawal penalties. If you were to liquidate the needed funds from an IRA or an old 401(k) plan, you would have to pay taxes on the amount withdrawn. As well, if you're under 59½, you would have to pay a 10% early withdrawal penalty. But you can borrow money from a 401(k) plan without any tax consequences whatsoever.
  5. High loan amount. From how many other loan sources can you borrow up to $50,000 on little more than your signature?
  6. No complicated application process. Since you don't have to be credit qualified, all you have to do is fill out an authorization form and get your loan. The proceeds can arrive in a matter of days.

Bottom line

Take a 401(k) plan loan if you absolutely need to, but never get carried away with the practice. Like a credit card, it can be easier to get deep in debt on a 401(k) loan than you might imagine. And then you'll just have to dig yourself out of that hole.

Kevin Mercadante Freelance Contributor

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com.


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