Are 401k Loans Hazardous To Your Wealth?

If you've done any research on taking 401k loans, then you've probably read that it is not the best thing to do for your financial future. Unfortunately, we're not going to tell you any differently. 401k loans really can be a detriment to your retirement.

Is taking a loan from your 401k always bad? Not necessarily. There are times when taking a loan might absolutely make great sense-but these times should be limited to moments of financial hardship where your only other options may be losing a necessary asset (such as a home) or taking a withdrawal from your 401k. Losing a necessary asset is not a good option for obvious reasons, and taking a withdrawal from your account is no good either since you will pay taxes and a 10% early withdrawal penalty on any money you take. In this case, taking a loan if you have one available is a good option. At least you are paying it back.


The theory behind 401k loans is severely misleading, and as such is widely misunderstood. On the surface a loan sounds like a grand idea. You withdraw your own money from your account and repay it over a number of years with interest that goes back to you. No harm, no foul! What could be better than that? Well, when it's said like that, it does sound pretty good. But take a look at the big picture.

There are two major factors that make saving for retirement feasible. These two factors are: time and compound interest. The more you have of each, the better off you are going to be in retirement. But when you take money out of your account you disrupt the natural flow of the two major components that make building a sizable nest egg a possibility. As a result, you lose money.

Let's take a look at an example to show you what we mean:

Let's pretend you are 40 years old with plans to retire at age 65. You have $100,000 saved in your 401k, and you are considering taking a loan of $50,000 (the max you can take) for 5 years to pay for a new car and to help fund a vacation. The loan carries a 7% interest rate which you pay back to yourself and the stock market is returning an average of 10.4% a year*.

We'll first say that after some serious thought you decide NOT to take the loan after all (smart move, by the way). At 10.4% annual return, the $50k you decided not to loan yourself would be worth $82,000.29 after 5 years without any additional contributions.

Now let's change things up and say that you DID decide to take the loan. That means over the course of 5 years you would pay back the $50k plus $3,500 in interest (7% on $50k), or in other words roughly $10,700 per year. But instead of paying it back through your regular payroll deductions you actually pay $10,700 back in a lump sum on January 1st each year for the full 5 years. This way you get the full benefit of the stock market returns for the full year**.

If you repaid your account $10,000 a year plus 7% interest ($700) AND received an annual return of 10.4% (for a total of 17.4% annual interest), the $50k you borrowed would only be worth $72,694.81 after 5 years. This is $9,305.48 less than you would have had had you not borrowed the money in the first place!

You may be looking at the difference and thinking, "that's not too bad. I can make that up in a year." But let's take it one more step further. We've already determined that the loan you took cost you $9,305.48 right now, but what does that do for your retirement account at age 65? Well, at 10.4% annual return that figure of $9,305.48 turns into a whopping $110,399.12!

The bottom line: In this example, a $50,000 loan today costs you $110,399.12 in retirement assets tomorrow. That's not chump change.

The preceding example is merely one (very valid) reason of why you shouldn't take a loan. But there is another very strong argument against it: double-taxation. Maybe you've heard of this before.

As you know, when you contribute to your 401k plan, you make contributions on a pretax basis, meaning you don't pay taxes on the money you defer. If you decide to take a loan, you are actually making a withdrawal on your account with the promise to pay it back, so no taxes are actually withheld on that withdrawal.

Good ol' Uncle Sam wants his cut, though. When you make the repayments from your paycheck, those deductions actually occur on an after-tax basis, not pretax like your normal deferrals. So essentially, you've now paid taxes on the money that you repaid.

However, when the repayments hit your account, they are applied as pretax contributions and combined with your regular employee deferral sources, so no distinction is made between your pretax deferrals and loan repayments. Fast forward to your retirement years when you actually take a distribution, you are paying taxes on everything you withdraw, including any loan repayments you made that you have already paid taxes on. Hence, the double-taxation "argument".

We call it an "argument" because there are some experts who say you are not really taxed twice. Their reasoning, they say, is because you are getting use of the money twice. Once when you pull it out in the form of a loan, and once when you distribute it during retirement. "How can you be taxed twice on money you have the ability to use twice," is what they say.

Regardless of which camp you fall into, there is no disputing that you are taxed twice on the interest. This is because you pay taxes on it as it goes into the account and also when you withdraw it in retirement, but you only get the use of it once (during retirement).

Hopefully we've made a convincing case against using your 401k as a loan vehicle for non-emergency reasons. If you have valid reasons for tapping your 401k, a loan is certainly a better option than a withdrawal. Be cautious and think twice before you decide to dip into it because you are potentially draining your main source of retirement income.

Notes:

*Over the last 80 years, the stock market has generated an average annual return of 10.4%. Returns fluctuate drastically from year to year, so this does not mean that it is guaranteed to return this amount in the future. Future returns could be higher or lower, but past performance is indicative of how it could perform in the future. The figure of 10.4% is used for illustrative purposes, and we are not suggesting that 10.4% returns are inevitable.

**We understand that no one will make loan repayments in this fashion. They are always done through continuous payroll deductions. The repayment was illustrated in this fashion to keep calculations simple. However, this proves something very important: because in the real world loan repayments are made throughout the year, you would have never had such a large sum of money working for you from day one. The $10,700 would have been placed into your account in small chunks throughout the year, meaning that the return you would have realistically received would be much lower than what was in this example. This is even more eye-opening.

By: Guide-to-Retirement-Plans.com

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