The Real Cost of Retirement Plan Loans
Still, lots of people are attracted to retirement plan loans because of the low rate and the fact that you're paying this interest to your own account. The latter feature is what leads many people to proclaim that 401(k) loans allow you to “pay yourself back.”
But are you really? Well, yes and no.
You are “paying yourself back” in the sense that you're not paying interest to a bank. But if you hadn't withdrawn the cash for the loan, that money would still be invested in something in your account, and that something probably would have been earning interest or other returns all on its own.
So instead of letting your investments earn returns, you have to dig those returns out of your own wallet.
Some of my readers have bragged to me that they were glad they took out 401(k) loans in 2000, when stock prices slid sharply and many people noticed steep declines in the value of their retirement plans. At least, they said, the money they'd borrowed was earning a steady, positive return, even if it was coming out of their own pockets.
But you can't know in advance how your investments will fare over the next five years. Many folks who borrowed against their 401(k)s when stocks were soaring more than 20% every year in the late 1990s kicked themselves for pulling money out of their investments to fund a loan.
Foregone returns on borrowed money aren't the only hazard of retirement plan loans. Another real problem is how quickly an innocent little loan can turn into a big tax nightmare.
Most workplace retirement plans require you to pay back a loan almost instantly if you lose your job. If you can't come up with the cash, the loan becomes a withdrawal. And that's not good.
Withdrawals are considered taxable events, which means you'll owe income taxes on that unpaid balance. If you're younger than 591/2, you'll also owe penalties for premature withdrawal (10% for the feds, plus whatever your state assesses). You could easily face a tax bill equal to one-third to one-half of the outstanding loan—just as your major source of income has been shut off.
Here's an example. Suppose Joe gets laid off owing $10,000 to his 401(k) plan. Since he's in the 25% federal tax bracket, he'll owe $2,500 in federal income taxes plus another $800 or so in state income taxes (he lives in California, where income taxes range up to 9.3%). The feds will want another $1,000 as a penalty for the early withdrawal, and California will take $250. In short, $4,550 of his $10,000 withdrawal—or 45.5%—will be eaten up in taxes and penalties.
Something similar can happen if you miss even one payment on your retirement plan loan. Skipped payments can trigger a default, and your unpaid balance is treated as a withdrawal.
The potential tax bill, bad as it is, is not the only thing you need to worry about. After you have withdrawn money from a workplace retirement plan, you can't put it back. The $10,000 you withdraw now could have grown to $49,268 in 20 years, $109,357 in 30 years, or an amazing $242,734 in 40 years, assuming an 8% average annual return. So each $1 you withdraw at age 35 could cost you about $24 when you're 75.
Your money can grow thanks to the power of compounding—your returns earning returns of their own. You don't want to mess with that if you can possibly help it.
There are some exceptions to the rule that a job loss means an instant loan payback. Hewitt Associates found that 29% of large company plans allowed former employees to continue making payments on their 401(k) loans. If yours is one such company, the risks of a 401(k) loan are lessened. (If you don't have a new job to replace the one you lost, that may be tough, but at least it's easier than trying to come up with a lump sum.)
You need to consider one other issue before taking out a retirement plan loan. Is it possible that this borrowing will be a crutch to help you continue overspending? As with home equity borrowing, a retirement plan's low rate and easy terms can lead people to think they've “solved” their high-rate debt, when all they've really done is covered up the problem.
If you pull money out of your retirement plan to pay off your credit cards, and then you run up more credit card debt, you haven't solved anything. In fact, you've made matters worse. You've put your retirement at risk to pay for meals, clothes, and movies long since forgotten. You haven't figured out how to live within your means, which means you'll probably be facing another debt crisis in the not-too-distant future.
Besides, credit card debt generally is something you should be paying out of your current income. Stretching it out over five years might actually increase the debt's total cost. You may find that if you take another look at your spending, you can carve enough money out of your budget to pay off the debt much faster and without the potential disadvantages of a retirement plan loan.
If you've considered all this and you still want to go ahead, take the following steps:
Fix the leaks. If you're using the money to pay off past overspending, make sure you create—and stick to—a spending plan that prevents you from going into further debt. For the time being, at least, put away your credit cards and live on cash.
Check your plan's repayment policies. You'll want to know if your loan will be called in if you lose your job or if you'll have some time to pay it off.
Have a Plan B. If your company demands loan repayment when you leave your job, make sure you have some other source of cash you can tap to pay it off. Keep plenty of open space on a home equity line of credit or your credit cards, for example—enough to pay off the loan and to provide your living expenses for the several months you may need to find your next job.
Pull the money from your fixed-income investments. If you have a choice, ask that the money for your loan be taken from your bond, cash, or other fixed-income investments, rather than from the stock side of your retirement plan portfolio. You don't want to miss out on the potentially higher returns that stocks can offer.