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The True Cost of 401(k) Loans

During the financial crisis, many cash-strapped workers resorted to 401(k) loans to make ends meet. But by doing so, they paid a higher cost than most of them realized.

In the following video, Fool contributor Dan Caplinger takes a look at the true cost of 401(k) loans. Although many people like these loans because you're essentially paying interest to yourself rather than to a big bank, Dan points out that the interest you pay to your 401(k) plan ends up getting taxed again when you withdraw it in retirement, creating a double tax hit. More importantly, Dan notes that money you borrow from your 401(k) loses its opportunity to earn returns from investment, which over the past several years has added up to substantial lost profits. Before taking a 401(k) loan, make sure you know exactly how much it could cost you in the long run.

Being smart about investing is an essential part of managing your 401(k), and the best investing approach is to choose great investments and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


Read/Post Comments (5) | Recommend This Article (4)

Comments from our Foolish Readers

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  • Report this Comment On June 16, 2013, at 10:37 AM, DennisMack wrote:

    I must quibble with your observations. If a person needs a loan and borrows from a lender, he will pay his interest with after tax dollars and his earnings on the money not borrowed in the 401(k) plan will be taxed when withdrawn. The loan from the 401(k) plan is like buying a fixed income security with yourself as the debtor. It should be a good fixed income investment.

    The interest paid is not always less than what could be earned by an equity portfolio. Back in 1987, I took a 401(k) loan. I paid myself a reasonable interest rate - as I would get in the market - and the equities market collapsed. It was to my advantage to have increased my fixed income portion of the portfolio, something many 401(k) investors do not do.

  • Report this Comment On June 16, 2013, at 11:58 AM, Maximizese wrote:

    My wife started work in 2008 and we've been maxing our her 401k contributions since. In 2012, we decided to move out of our 1bd/1ba apartment after we finally found a nice house for a reasonable price (short sale); coincidentally, our rent was going up for the first time in 4 years too. We decided to liquidate some mutual funds I've held for over a decade and to take a loan against her 401k.

    The fees were low ($220 for 5 years or $3.67/month), taxes, and 1% interest paid back to the fund. I figured her 401k was up some 40% and it would be wise to rotate assets from one that had done well and wouldn't be of use to us for another 33 years, with one that we could use now and potentially increase in value. We borrowed $32K from the 401k to bring our downpayment up to 25%. We bought the house for $625K a year ago and our current Zillow value is currently $840K. We have no regrets in taking the loan and have the cash reserves to repay it tomorrow if obligated. The double-tax issue didn't bother us because he knew we'd be getting a huge tax break from being first-time homebuyers and the cost of loan from any other institution wouldn't have been as favorable.

  • Report this Comment On June 16, 2013, at 12:06 PM, RoscoP7777 wrote:

    He makes a couple of assumptions. The possible loss of income in an up market can be offset by a lack of losses in a down market. We also have to assume that a person taking out a loan from their 401k actually needs a loan. If I am going to need a loan then why not borrow it from myself rather than borrowing from a bank where I will pay higher interest rates AND I will be making the payments using post-tax money.

    There are shortcomings to most types of loans and 401k loans are no exception but paying interest to myself seems like a better idea than paying interest to BofA.

  • Report this Comment On June 16, 2013, at 12:45 PM, rfmcbob wrote:

    Dan, I understand your concern but when you consider the spread between consumer loans and 401K loans, for the most part the benefit weighs in with the 401K loan. Extraordinary bank profits, especially from fee income, coupled with minimal cost of borrowing for banks, costs each consumer well beyond the tax consequences. With the tremendous run up of the market, one can be sure that the principal money movers will bring the market down, can you say 2007/2008!!. I wake up each day expecting that they have begun the process. They made money bringing it down, they made more money bringing it back up and they will do it again!!

  • Report this Comment On June 16, 2013, at 7:18 PM, Retiree2035 wrote:

    I took a loan for half of the value of my 401K in June of 2008 before the crash and I didn't even need the loan. I would have lost half of that money had I kept it in the 401K and eventually 5 years later I would have been back where I was had I done nothing. The price was $50 at the time and is now $58. I got over 10K in cash and got to repay my loan when the market dropped, flattened and eventually rose back up. Whatever percentage of interest or taxation I will suffer in my retirement years for the loan does not compare to the money I saved with this loan. I essentially sold high and bought low with my 401K. There was almost no other way I could have protected my 401K principal without the loan. I have no regrets about the loan and think it was possibly the best investment decision I ever made with my money.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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