Monday, October 17, 2011

The Cost of a Loan Taken From Your 401(k)

Borrowing from your 401(k) can be expensive in a way that you may not have thought of.  In my June 9th Article I wrote about some of the good and bad characteristics of 401(k) loans. However, there is a not so obvious cost in the loan that you should be aware of.

As you may know, 401(k)s are funded with pre-tax dollars. This is great because you delay paying income tax on your contributions until you start taking money out of your 401(k) account. To be clear, a loan is not a distribution. So, you do not pay income tax on a loan…sort of. Here is an example of what can happen. Let’s assume your marginal tax rate (MTR) is 25%.  
  1. Over time, you’ve contributed $10,000 to your 401(k) in pretax dollars.
  2. You decide to borrow $1000, maybe you want a new TV
  3. There’s probably a loan origination fee, maybe $50
  4. Loan interest rate may be a little high, but you’re paying it to yourself…~5%
  5.  You pay back the loan over a one year term. Including interest, you’ll have to pay back $1028. Unfortunately, you do it with post-tax dollars. With an MTR of 25%, you’ll have to earn $1371 to pay back the original $1000.
In the end, that $1000 loan cost you $421 ($50 + $371). Naturally, the cost scales with your MTR, interest rate, loan term and amount borrowed. But as you can see, the repayment using after tax dollars is expensive. And here's another no so obvious cost. When you finally take distributions from your 401(k),  you'll have to pay tax on 100% of the distributions. So, before you decide to borrow money from your 401(k), carefully consider all of the costs and risks.

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