Is a 401(k) Loan Feature in your Retirement Plan Really a Benefit?

June 9th, 2008 at 04:20pm Kim S. Cady

  Kim Cady 

Many 401(k) plans today allow participants  the ability to borrow a portion of their plan balance.  Most participants consider this a valuable plan benefit.  But is it? A program that lets you pay yourself back sounds like a great deal, but remember, you are the one doing the payback, typically pulling cash out of your paycheck (on an after-tax basis) and putting it back into your plan (to be taxed again later!)   One may argue that these participants are just taking out of one pocket and putting it into their other pocket–virtually costing them nothing.  Let’s see if this holds true: 

A 45 year old participant borrows $5,000* with an interest rate of 6% to be paid back over a 3 year period.  The participant’s current plan investments would otherwise earn an average of 8% a year.   

The participant’s take home pay will be reduced by $152.11 per month; over the course of the 3 year period, total interest paid is $475.95 for a total repayment back to the plan of $5,475.95.   

Yes, the participant’s plan balance will have an additional $475.95 after the 3 year period, but remember this was paid by the participant.  The same $5,000 if left in the plan would have earned $1,298.56 (compounding annually) from the investment company.  The participant is out all of this income and the plan is short by $822.61.  Now let’s take this one step further.  What if this shortage had remained invested in the plan the remaining 22 years until the participant retires?  It would be worth $4,472.15!   Without doing any additional math, this seems to be a pretty costly loan.  (The same loan through a financial institution at a rate of 9.5% would cost the participant $765.93 in interest over the three year period.)    A better alternative would be taking a home equity loan which may allow the interest to be tax deductible.  Of course, if there is a financial emergency, it’s always better to borrow from your plan than take a hardship withdrawal (if under age 59.5).  You avoid the 10% penalty and at least the proceeds will be returned to the plan over time.   *The plan document and/or the plan’s loan policy may restrict the availability of the loan to specific purposes.  You should refer to your Summary Plan Description or your plan administrator for further information.

Entry Filed under: Retirement Planning, Investments