Understanding the Costs of a Retirement Plan Loan
Some employers allow you to take out a loan from a 401(k) or 403(b) plan. As your retirement plan account contributions add up, it may be tempting to borrow money from the retirement account balance.
If you're thinking about getting a loan from a 401(k) or other type of retirement plan, make sure you understand the rules, look at the pros and cons, and consider other loan options before making your decision.
How does a retirement plan loan work?
There are some rules that affect retirement plan loans. If your company's retirement plan does allow loans, some examples of loan provisions include:
- You can borrow up to 50% of the vested account balance or $50,000, whichever is less, according to federal law
- Sometimes there is a minimum amount you must borrow
- You usually have a maximum of five years to repay the loan, unless you are borrowing for a first home (if your company's plan allows), which allows a longer payback
- You may be charged loan origination fees and quarterly fees
When you borrow against the retirement account balance, you sign a loan agreement that spells out the principal, the term of the loan, the interest rate, any fees, and other terms that may apply. You may also have to wait for the loan to be approved. If you're married, your plan may require your spouse to agree in writing to a loan.
So what does it really cost to take a 401(k) or other retirement plan loan?
With a loan through a retirement plan, you pay yourself back the amount of the loan plus interest. However, with a plan loan the true cost can be shown with the loss in retirement savings. Retirement savings are lost when you borrow from a retirement plan because:
- You may lose potential growth on the earnings, or compounding of those earnings.
- You repay the loan with after-tax dollars.
- There may be an initial set-up and quarterly loan fee.
- Many participants decrease the amount they are contributing in order to compensate for the loan payment.
- You may not be paying yourself back the same amount you would have earned if you left the money invested (you pay yourself back at 7% interest, but may have been able to earn more within the investment options).
An example: a retirement plan loan vs. no retirement plan loan1
The chart below outlines the cost if you take a $5,000 loan at 5% interest from a retirement plan, with a $20,000 account balance. You previously made contributions of $150 per paycheck (including employer match) to the retirement plan. However, because you need to repay the loan, you decreased your contributions by $44. Additionally, prior to the loan, you were earning 8% return on the retirement funds. You'll repay the loan over 5 years.
|Amount or percentage||Retirement Plan Loan2||No Loan3|
|Loan Period||5 years|
|Interest Rate of the Loan||5%|
|Account Balance at Age 65||$607,800||$659,800|
Consider other loan options before taking out a retirement plan loan
1) Assumptions for both scenarios:
- Initial account balance of $20,000
- 8% return on retirement plan
- Rates of return are hypothetical and do not represent the return of any particular investment option
2) Assumptions for the plan loan scenario:
- Participant takes out a $5,000 loan at age 35 and repays it in 5 years
- Participant will contribute $150 (including loan payment) during loan period
- Participant will contribute $150 after loan has expired
3) Assumptions for the no loan scenario:
- Participant takes out no loan of any kind
- The participant makes regular contributions of $150