The True Cost of a 401(k) Loan

A 401(k) loan is one way to finance major purchases. For those nearing retirement, but not quite there, borrowing against your 401(k) assets is one way to tap into your benefits before you retire.

Like many pre-retirees, you may be thinking about final home renovations, a second property, or a new toy. With your retirement benefits near an all-time high, and when mortgage and personal loan rates are high, a 401(k) loan can sound like a great option.

What is a 401(k) Loan?

A 401(k) loan is a provision allowing you to borrow up to 50% of your vested account balance. Typically, loans are capped at $50,000 of your 401(k) savings and must be repaid within 5 years (with an exception for loans used to purchase a primary residence, which may qualify for a longer repayment period).

The main reason people are attracted to 401(k) loans is the way interest is paid. In a personal or mortgage loan, the interest you pay goes to the bank. That's the cost of borrowing. The interest on a 401(k) loan, however, is paid back to yourself. It sounds nice to "be your own bank," but borrowing against yourself comes with advantages and disadvantages.

Advantages

• No taxes or penalties (assuming you pay back the loan).
• Interest rates are typically low.
• The interest paid goes back into your account, making the interest cost of borrowing effectively 0%.
• No credit check, and therefore a quicker loan process.

Disadvantages

• If you separate from your employer with an outstanding loan balance, most plans treat the unpaid amount as a taxable distribution. Under the Tax Cuts and Jobs Act of 2017, you may have until your tax filing deadline (including extensions) for that year to roll the outstanding balance into an IRA or another qualified plan to avoid taxes and penalties — but plan rules vary, so confirm with your plan administrator.
• Any loaned money is left uninvested, and will not grow alongside invested assets. That's lost growth.
• Loan repayments are made through after-tax dollars (you've already paid tax on that money). Once you retire, distributions from a traditional pre-tax 401(k) will still be taxed as income. You're essentially taxed twice on the borrowed amount.

The True Cost of Borrowing

When you're comparing loan options, interest rates get the majority of the attention. And rightfully so. Who wants to pay more interest to the bank? When the cost of borrowing is 0%, a 401(k) loan can look especially attractive compared to a traditional loan. It's better to pay interest to yourself than the bank, right? Not always!

Any money borrowed from your 401(k) is left uninvested and will not grow alongside your invested assets. The true cost of a 401(k) loan is not the interest rate, but the opportunity cost of leaving money uninvested. So, the right comparison isn't 401(k) interest rates versus personal loan rates; it's how much in returns could be lost after letting 401(k) assets sit uninvested. The true cost hinges on the expected returns in the 401(k) plan.

Hypothetical illustration only. Return figures are not projections of any specific investment. Past performance does not guarantee future results.

Let's say Stacey and John both take a $50,000 loan from their 401(k) at the same interest rate. The opportunity cost is twice as high for John as for Stacey.

John has $50,000 uninvested. The rest of his 401(k) will grow at 8%, but the amount he loaned will not grow at all. Stacey, on the other hand, has a 4% expected rate of return on her 401(k). She's still giving up future growth, but the expected growth that she forgoes is less compared to John.

Simply put, the more growth you expect from your 401(k), the more future growth you forgo when you borrow against your 401(k).

Both John and Stacey have a 3.5% interest rate on their 401(k) loan. Again, the interest cost is paid directly back to their 401(k) — not a bank. So, the interest cost is 0%, right? Not exactly. Interest is the cost to get their uninvested loan balance back into the market.

The true interest cost is the cost of getting back into the market. While the interest is paid back to both borrowers (not a bank), they're essentially charging themselves 3.5% to get their uninvested balance back into the market.

When a 401(k) Loan Makes Sense

401(k) loans can slow your investment growth at a time when compounding interest is working the hardest for you. If you're nearing retirement, your account balances are likely the highest they've ever been. And the growth on that money today changes your account balance more than ever. However, there are still scenarios where a 401(k) loan can make sense.

• The borrowed amount is low and paid back quickly.
• The invested assets are conservative, and the expected rate of return is low. (If this is the case, you should make sure your portfolio aligns with your capacity to take risk).
• The borrowed amount goes to refinance high-interest-rate debt.
• The borrowed amount is used to bridge a cash flow gap before receiving a lump sum of cash. (For example, you need to fix a leaking pipe in your house before you sell it — and the home sale proceeds immediately pay off the 401(k) loan).

Choosing whether a 401(k) loan is right for your situation is a major decision, especially as retirement approaches. At Voyage, we help pre-retirees on the Mississippi Gulf Coast evaluate their lending options so they can better navigate major purchases before retirement.

In Summary

Deciding if a 401(k) loan makes sense involves much more than evaluating interest rates. As your retirement date creeps up, even the small decisions you make create a lasting impact in retirement. And with several moving parts, these decisions are best made within the context of a financial plan.