Current Thinking

Thinking of Taking a Loan from Your 401(k)? Not So Fast!

A blog by Richard Rausser, CPC, QPA, QKA, Senior Vice President – January 6, 2015

All of us could use a little extra money, either to purchase gifts for family and friends outright, or to pay the bills. One seemingly simple way to raise some quick cash is to borrow money from your 401(k) … which, as you may suspect, is something that I strongly discourage.

Not that it’s an unheard-of idea. According to an analysis of over 900,000 401(k) participants by the University of Pennsylvania’s Pension Research Council, an average of 13,000 participants take a loan each month for a median of about $4,600.

Instead of building for your retirement, that withdrawn money is now being used in a very short-sighted manner. Taking a plan loan means that you will have less money “invested” in the plan – so rather than earning, for example, a 7 percent return, the loan will cost you 4-5 percent each year. With a loan of just $1,000, you also may be required to pay a loan origination fee of upwards of $100, plus ongoing annual maintenance fees of $40. That means that over the term of a five- year loan — and 401(k) plan loans typically must be repaid within five years — you’ll pay $300 in fees plus interest on the loan of $110 – that’s over 40% of the original loan amount!

Increase that loan amount to just $2,500, and the long-term impact over a 30-year period is over $20,290. Take a look at this chart from Alliance Benefit Group:

Defaulting Can Cost You Big.

 

 

Staying Invested until retirement

Defaulting

Value of loan Today

Annual Rate of Return

5 years

15 years

30 years

Taxes and Penalty to the government assuming defaulted balance (assuming 30% Federal and State taxes and 10% penalty)

$3,000

7%

$4,252.88

8,546.84

$24,349.49

$1,200

$5,000

7%

$7,088.13

$14,244.73

$40,582.49

$2,000

$10,000

7%

$14,176.25

$28,489.47

$81,164.97

$4,000

$15,000

7%

$21,264.38

$42,734.20

$121,747.46

$6,000

*This chart is an example only and not a guarantee of future earnings or balances. This letter and accompanying chart should not be construed as investment advice. Individuals are advised to consider any new investment strategies carefully prior to implementing. Prior results of an investment are no guarantee of future performance.

This brings up another important point. While it’s never a good idea to default on a loan, what happens if you leave your job? Your loan will be in default after just a few months of non-payment; once you are in default, taxes and a 10 percent penalty will apply to you if you are under 59 1/2 years old. Not only that, but if the loan is large enough, that extra income may push you into a higher tax bracket.

And if you have cut back on your 401(k) contributions to be able to pay back the loan, you will again be in the position of not making your money work for you — not only due to the obvious loss of the extra investment dollars on your end, but also due to the smaller amount of dollars contributed by your employer as a matching contribution.

The negatives of taking a loan should clearly outweigh the short-term benefits. And remember: If you do leave your job, that 401(k) money should always be kept in a tax-deferred vehicle. Among your choices:

  • Keep the money in your prior employer’s 401(k) plan (permitted if your balance is more than $5,000)
  • Roll the balance directly into a rollover IRA
  • Roll the balance directly into your new employer’s 401(k) plan

Never simply take a distribution and pay taxes — and maybe a penalty — on the distribution.

About the Author:
Richard W. Rausser has over 30 years of experience in the retirement benefits field. He is Senior Vice President of Client Services at Pentegra Retirement Services, a leading provider of retirement planning services to financial institutions and organizations nationwide, founded by the Federal Home Loan Bank System in 1943. Rausser oversees consulting, BOLI, actuarial, communications, and marketing practice groups at Pentegra. He is a frequent speaker on retirement benefit topics; a Certified Pension Consultant (CPC); a Qualified Pension Administrator (QPA); a Qualified 401(k) Administrator (QKA); and a member of the American Society of Pension Professionals and Actuaries (ASPPA). He holds an M.B.A. in Finance from Fairleigh Dickinson University and a B.A. in Economics and Business Administration from Ursinus College.

About the Author

Richard Rausser

Richard W. Rausser has over 25 years of experience in the retirement benefits industry. He is Senior Vice President of Client Services at Pentegra Retirement Services, a leading provider of retirement plan, fiduciary outsourcing and institutional investment services to organizations nationwide. Rausser oversees the consulting, marketing and communications, non-qualified plan and BOLI business development and  actuarial service practice groups at Pentegra. He is a frequent speaker on retirement benefit topics; a Certified Pension Consultant (CPC); a Qualified Pension Administrator (QPA); a Qualified 401(k) Administrator (QKA); and a member of the American Society of Pension Professionals and Actuaries (ASPPA). He holds an M.B.A. in Finance from Fairleigh Dickinson University and a B.A. in Economics and Business Administration from Ursinus College.




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