How a 401k Loan Affects Future Wealth

Could you be hurting your retirement by taking a 401k loan now? Borrowing your own money rather than taking out a conventional loan does have its advantages, but you also need to consider how a 401k loan will affect your future wealth.

by Gary Foreman

How a 401k Loan Affects Future Wealth photo

Many people who take out 401k loans are drawn to the idea that it can be cheaper to “borrow your own money” than to borrow from someone else. Sure, you might save in interest over the next few years, but borrowing from your 401k could come at a cost, namely to your retirement.

To help us understand how 401k loans work and what affects they have on the saver’s future wealth, we contacted Ryan C. Edwards. Mr. Edwards is a Certified Financial Planner® and an investment executive at CornerstoneShreveport.com. He works with individuals to help them achieve overall financial success.

Q: What exactly is a 401k loan?

Mr. Edwards: A 401k loan is a loan taken from a retirement plan’s balance by the participant. It is important to note that not all 401k plans allow for loans, so a participant should check with their employer to find out if their plan allows loans.

The loan is typically limited to the lesser of half of the vested balance or $50,000. If the vested balance is $20,000 or less, the loan is limited to the lesser of $10,000 or the entire vested balance. A normal time frame for repayment of the loan is five years, and this is usually done through payroll deductions; however, a loan taken for purchase of a primary residence typically has a longer repayment period, possibly as long as thirty years.

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Q: The standard reason given for taking a 401k loan is that you’re borrowing your own money and all interest you’re paying comes back to you. Almost like getting a free loan. Is that true? Or is there an error to that logic?

Mr. Edwards: In a sense, this is true because you are borrowing and paying interest on your own money; however, you must be aware of any fees associated with the taking the loan. It is customary for plan administrators to charge both a loan issuance fee and an annual fee, and these can range in price. Any decision regarding a 401k loan needs to take into account the interest rate and the fees associated with the loan.

Another variable you want to consider is the anticipated rate of return within the retirement plan. If you anticipate a 10% return in the plan but will only be paying an interest rate of 6%, then the plan balance will not grow as quickly. Because of compound interest, this could have a lasting impact on your retirement balance, especially if you are taking the loan relatively early in your work life.

Q: What are the downsides to a 401k loan?

Mr. Edwards: The primary downside of taking a 401k loan is failure to repay the loan. These loans are required to be paid in a specific time period and in a specific manner. If you miss a series of payments, you are at risk of the loan being treated as a distribution from your plan. If the loan becomes a distribution, then it is taxable on the date of the original loan. Additionally, the distribution, if not qualified, would incur a 10% penalty.

A key consideration when taking a 401k loan is your likelihood of remaining employed with the plan sponsor over the life of the loan. Although it is dependent on the plan, it is common for the balance of the loan to be due upon termination. Being able to come up with a lump sum payoff may be difficult; again it is important to know your specific plan’s provisions regarding 401k loans.

As mentioned before, another downside may be the loss in future gains. If the rate of return in the 401k is much higher than the interest rate paid, then you will miss out on gains in your retirement plan.

Q: Is there a way to estimate how a 401k loan today will affect the value of the account years from now at retirement?

Mr. Edwards: There are several online calculators available that can estimate the impact of taking a loan from a 401k. I entered “401k loan calculator” into a search engine and found an easy-to-use calculator on Bankrate.com. These calculators are not likely to account for plan fees, so again, you want to be aware of those costs.

Q: What alternatives should be considered to a 401k loan?

Mr. Edwards: Depending on the need and resources available, there are alternatives to a loan from a 401k. I am a firm believer in the bucket approach to finances. I believe it is important to have an emergency fund of cash (savings account), retirement assets in qualified accounts (401ks and IRAs), and then also non-qualified investment assets that can be invested (brokerage accounts). 401ks are really geared to planning for retirement, and I don’t like to see clients start a habit of borrowing from money that is set aside to fund their lives when they cannot or do not want to work anymore. Cash in a savings account can be used for emergencies and assets in a brokerage account can be liquidated for emergency needs or non-emergency wants.

Another alternative is a home equity line of credit; however, the interest payments will go to the lender. This may be a better option if you need more money than can be loaned from your 401k and you don’t have any other resources available.

Q: Are there certain situations where a 401k loan is called for? Or others, when it’s definitely a bad choice?

Mr. Edwards: Every situation is different with different variables, but I look at the why behind borrowing money. From a financial planning perspective, I believe that it is important to establish whether the desire to take a 401k loan is for a need or a want. Is it worth risking retirement assets for a nicer car or a bigger house? Is there a real financial emergency? How is a client going to use the funds? If the loan is for a short-term want, then most times that is a bad choice. Again, I encourage clients to have an emergency fund to address unexpected costs so that funds are available specifically for a financial emergency. However, if funds outside of the 401k are not available, then a loan may be needed to meet an obligation.

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.