401(k) loans have become a popular source of credit. They have interest rates that are almost always lower than the alternatives. Because they’re secured, you don’t run the risk of building up large amounts of unsecured debt. And if they’re offered by your employer, you can get them without even having to qualify based on your credit. The payments can be handled out of your paycheck so you hardly know that it’s happening.
But the very simplicity of borrowing against your 401(k) plan covers up some hidden dangers that you need to be aware of if you’re considering taking out a 401(k) loan — even for a down payment on real estate.
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 that you pay on the loan becomes the income that you earn on that portion of your plan. So instead of earning stock market-level returns on your 401(k) plan investments, you instead “earn” the rate of interest 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 the 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. In addition, 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 amount of the unpaid loan balance. You will also have to pay your state income tax rate on the 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 will 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 to 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 has real potential to compromise the real purpose of your plan, 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 long-term value and performance of the plan — 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 the vested balance of your plan, 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.
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.