401(k) plans can be a great way to save for retirement, letting you set aside money in a tax-favored account that is free to enjoy long-term growth from the investments you use within the plan. Yet many people see their 401(k) plans as a quick source of easy financing, with employers often allowing employees to borrow a portion of their retirement money through 401(k) loans for whatever reason they choose. As attractive as a 401(k) loan can seem, borrowing money from your retirement comes at a much greater cost than you might realize. Let's take a closer look at 401(k) loans and why they carry a price tag that you probably don't want to pay.
How 401(k) loans work
The laws that govern 401(k) plans allow participants to take 401(k) loans as long as the employer plan specifically allows for them and they meet the requirements for qualified loans. Employees can borrow as much as half their account balance in a 401(k) loan, unless that amount would be greater than $50,000.
As with any other loan, when you use a 401(k) loan to borrow from your retirement savings, you have to pay the money back. The maximum term of the loan is five years, unless the employee uses the money to buy a primary residence, in which case a longer period is allowed. Many employers provide for 15-year maximum repayment terms for loans used toward home purchases.
Despite these limits, there are two attractive elements to 401(k) loans. First, it's far easier to get a 401(k) loan than it is to apply for a loan at a bank or other lending institution. You don't need to give credit information, and often, you'll only need to complete a few forms to set things up. Moreover, your employer will typically take payments out of your paycheck automatically, making it simple to pay the loan back.
Second, because you're essentially borrowing from yourself, it's easy to think of a 401(k) loan as being interest free. Your 401(k) loan repayments will include interest, but that interest gets deposited into your plan account along with the repaid principal, and so your plan balance will go up by the interest amount.
The downsides of 401(k) loans
Unfortunately, the benefits of 401(k) loans come at a price. There are several ways in which a 401(k) loan can hurt your retirement prospects.
One common problem arises when you leave your job with a 401(k) loan outstanding. Most plans require immediate repayment of your loan within just a short period following your date of departure -- typically 60 days -- to avoid default. If you don't repay, the IRS treats the loan as a distribution from your 401(k). As a result, you'll have to pay income tax on the loan amount, and you'll typically have 10% early withdrawal penalties to deal with as well.
Yet the much larger cost of 401(k) loans comes from the fact that the money you borrow isn't invested. As a result, you miss out on the tax-deferred growth that the funds would have generated if you'd left them inside your 401(k). That might not sound like a big deal, but over time, it can really cost you.
For instance, consider a simple example. Say you're 50 years old and have saved $100,000 in your 401(k). You want to take a $50,000 401(k) loan to buy a new home, with the intent of repaying it over a 15-year period. Assuming you pay a 4% interest rate and your 401(k) investments earn an average annual return of 10%, here's the impact of taking the money out of your 401(k) through a loan.
As you can see, your account balance ends up $60,000 less by taking out a 401(k) loan than if you'd left your money alone. That's surprising, especially considering that the example does take into account the fact that you're repaying your 401(k) loan with interest -- interest that comes out of your own pocket. Yet the reason is simple: you've forgone strong investment returns by borrowing against your retirement. Moreover, even after you repay the loan, that shortfall in your account balance still exists and gets even larger in the future.
A 401(k) loan might seem like the easiest way to cover an unforeseen financial need. Yet as easy as it is to get a 401(k) loan, you need to consider the true cost of borrowing on your retirement prospects. Doing so could make you think twice about taking the 401(k) loan in the first place.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.