Tight credit and a slumping housing market that has reduced the use of home equity as a loan source is causing people to look in other directions to borrow money. And for those who are participants in 401(k) plans, there may be a loan provision in their plan to utilize. But there is a downside to consider.
- They’re losing the earnings on their accounts since there’s less money to invest.
- The tax shelter advantage is lost since the loan is paid back with after-tax dollars.
- The interest paid on the loan is not deductible since it’s considered regular consumer debt.
- If the participant terminates employement prior to paying off the loan, the loan has to be repaid or it’s considered a taxable distribution with a 10% penalty tax if the participant is under age 59 ½ .
Here’s an example of the financial impact of a 401(k) loan from T. Rowe Price. Assume that the participant has been making monthly contributions of $264 to his 401(k) account and has been earning annualized return of 8%. Now at age 40, he takes out a loan for $50,000 for 5 years at an interest rate of 7%. His after-tax monthly loan repayment would be $198 and he halts his monthly contributions to the plan.
By taking the loan:
- His balance at end of 5-year payback period would be $74,143, and
- His balance at age 65 would be $520,799.
But if he doesn’t take the loan:
- His balance at end of the 5-year payback period would be $93,891, and
- His balance at age 65 would be $618,095.
Taking the 401(k) loan reduces the employee’s account balance by approximately 21% at the end of the 5-year payback period, and by approximately 19% at age 65.
Something to consider.