60% of Retirement Savers Who Made This Financial Decision Regret It

According to a report from advisory firm Edelman Financial Engines, 60% of retirement savers who've borrowed money from their 401(k) regret the decision to tap those retirement funds. As well, 80% of borrowers say they didn't understand the implications of the loan prior to accessing the cash. Those implications include a likely reduction in take-home pay, along with missed contributions and lost earnings over time.

If you're considering a 401(k) loan, minimize the post-transaction regret by estimating the full costs and consequences of the transaction -- before you act. Here's how to do it.

Quantifying taxes and interest on your 401(k) loan

According to a recent Vanguard study, the median 401(k) balance is roughly $22,000. Let's assume your balance is in line with this median and you want to borrow $20,000 of it. That loan amount is possible, but only in 2020 -- coronavirus relief efforts temporarily raised the maximum 401(k) loan amount from 50% of your balance to 100%.

Image source: Getty Images.

First, ask your administrator what fees you'll be charged for taking out the loan. These may include one-time loan origination fees and annual loan maintenance fees.

Then, dive into the costs of repayment. A common interest rate on these loans is the prime rate plus 1%, which would be 4.25% currently. 401(k) loans normally must be repaid within five years with after-tax dollars. Using an online loan calculator, you can estimate that a loan balance of $20,000 paid back over five years at 4.25% requires monthly repayments of $371. As well, the total interest cost on this loan is $2,235. Note that those interest charges go into your own 401(k), so you could argue that they don't actually cost you anything.

You'll then use the monthly repayment amount to understand how the loan will affect your take-home pay. Before the loan, you were contributing some amount of pre-tax dollars to your 401(k), which lowers your federal and state income taxes. After the loan, you have swapped the pre-tax contributions for after-tax repayments. That change lowers your net pay unless your repayment amount is less than what you were contributing prior to the loan.

Review the details of your paystub or use a paycheck calculator to quantify the change. For context, an average worker earning $50,000 annually and contributing 7% prior to the loan might see a monthly income reduction of about $135, or more if there are state income taxes. The difference is comprised of higher federal taxes of $56 and a $79 increase in 401(k) payments.

Quantifying lost earnings on your 401(k) loan

Understandably, you might view the modest reduction in your take-home pay as a reasonable cost for accessing the cash you need. But a look at how your loan affects your 401(k) balance over time is far more startling. The table below estimates what your retirement savings balance will be after 30 years, with a loan and without one.

Table data source: Author calculations 

The saver who doesn't borrow is contributing $292 monthly with an annual growth rate of 7% to amass about $535,000 by 2050. The borrower enjoys the same annual growth rate and starting contributions but takes out a $20,000 loan at the end of 2020. The loan is repaid over five years at $371 monthly. Once the loan is paid back, the contributions return to the pre-loan level of $292.

As you can see, the ending balance for the borrower is roughly $126,000 lower -- a high price to pay for a $20,000 loan. Also, if this borrower wanted to catch up after repaying the loan, he or she would have to increase those monthly contributions to about $450 to reach that $535,000 balance by 2050. You can test out these numbers, and project your own, using the SEC's compound interest calculator.

You might wonder, too, if you can minimize the long-term reduction in your balance by continuing contributions while you are repaying. Most likely, the answer is no. 401(k) plans don't normally allow you to make new contributions until the loan has been fully repaid.

A word on defaulting

If you don't repay your 401(k) loan according to the terms, the IRS can deem it an "early withdrawal" rather than a loan. Early withdrawals are subject to income tax and, usually, a 10% penalty. (In 2020 only, the 10% penalty is waived for those affected by the coronavirus pandemic.) Beyond those extra costs, defaulting means you never fully restore the funds to your account, which can be disastrous to your savings growth.

The loan of last resorts

A 401(k) loan could get you out of a jam today, but it often creates new problems for you tomorrow -- namely, a meager savings balance at retirement. If you must take the loan, do it with full knowledge and acceptance of the consequences. Estimate the effect on your take-home pay during the repayment phase as well as the contributions you'll need to make after repayment to reach your savings goals. That doesn't guarantee you won't later regret your decision to borrow, but at least you'll know what's needed to get you back on track.