The math
The cost of a 401(k) loan is the return you miss.
A 401(k) loan looks free, because you pay the interest to yourself. It is not free. The cost is the growth that the borrowed money does not get. That cost changes with the market.
The rules
A plan can offer loans, but the law does not require it. The tax rules set a maximum. It is the smaller of $50,000 or the larger of $10,000 or 50% of your vested balance. For a $20,000 loan, you need a vested balance of at least $40,000.
You must repay the loan within five years. A loan that buys your main home can have a longer term. The payments must be substantially equal, with principal and interest in each one. You must pay at least once each quarter.
Where the interest goes
With a bank loan, the interest goes to the bank. With a 401(k) loan, the interest goes back into your own account. Thus the interest is not a loss to your household. But the loan has two other costs.
The borrowed money is not in the market. Your account gets your payments back over five years. It does not get the market return on the money while the loan is open. If the market rises, you miss that growth.
You pay tax on the interest twice. You pay the interest with pay that you already paid tax on. When you withdraw that money later, you pay income tax on it again.
This is what people call the "double tax" on a 401(k) loan. It applies only to the interest. You paid no tax when you borrowed the principal, so the repayment of the principal is not a second tax. At an assumed 22% rate later, the second tax on the interest in our example is $953.
Three ways to borrow $20,000
We compare three ways to pay for a $20,000 need over five years. The interest rates are assumptions for the example.
| Loan | Rate | Monthly payment | Total interest | Who gets the interest |
|---|---|---|---|---|
| Credit card | 24% | $575.36 | $14,522 | The bank |
| Personal loan | 9% | $415.17 | $4,910 | The bank |
| 401(k) loan | 8% | $405.53 | $4,332 | Your own account |
For the card and the personal loan, the interest is the cost. For the 401(k) loan, the cost depends on the market. We simulate 20,000 market paths. Each path has an average return of 7% a year and a volatility of 16%.
The cost of the 401(k) loan, in after-tax dollars
20,000 market paths, against a world where the money stays invested
- Average cost
- $3,691
- Median cost
- $2,978
- Worst 10% of paths
- $9,424 or more
- Best 10% of paths, a gain of
- $1,194 or more
The average cost is below the $4,910 of interest on the personal loan.
The cost has two parts. On average, the market return that you miss is $2,738 after tax. The second tax on the interest adds $953. Together, they make the average of $3,691.
The market return decides most of the result. If the market is flat for the five years, the only cost is the $953 of tax. If the market falls, the loan kept part of your money out of the loss. If the fall is large enough, the loan is a gain. That happens in 19% of our paths.
The 401(k) loan costs less than the personal loan in 67% of the paths. It costs more than the credit card in only 3% of the paths.
The risk: you leave your job
If you leave your job with a loan open, your plan can reduce your account by the unpaid balance. The IRS calls this a plan loan offset, and it treats the offset as a distribution. Check what your plan does with an open loan when you leave.
Suppose that you lose your job after two years, and the plan offsets the loan. The open balance is then $12,941. You can roll over the same amount into an IRA or another eligible plan, with money from other sources. If the offset occurs because you leave your job, you have until the due date of your tax return for that year. If you get an extension, the extended date applies.
If you cannot find $12,941 in time, the balance becomes taxable income. If you are under 59½, the 10% tax can also apply. At 22% plus 10%, the extra tax is $4,141. One exception applies if you leave your job during or after the year that you turn 55.
A loan can also default while you keep your job. If you stop the payments, the IRS generally treats a loan in default as a taxable distribution. Any early distribution tax can also apply. You cannot roll over this kind of distribution.
A cost that the model does not show
If the loan payment makes you decrease your 401(k) contributions, you lose those contributions and any match on them. Our model does not include this cost, and it can be large.
What to do
Do not pay a credit card rate when a 401(k) loan is available. The card costs $14,522 in interest. The 401(k) loan costs $3,691 on average, and less than $9,424 in 9 paths of 10.
Against a personal loan, the choice is close. The 401(k) loan is less expensive on average, but its cost is not certain. The personal loan has a fixed cost.
Before you borrow, think about your job. If you can lose it or leave it in the next five years, keep cash to repay the balance. If you cannot keep that cash, use a different loan.
Keep your contributions. Do not decrease them to make the loan payments.
What this leaves out
The model does not include state tax or plan fees. It adds the interest dollars with no discount for time. It uses one return assumption and one set of tax rates. Your plan can have rules that are stricter than the IRS limits.
Sources
- IRS, Retirement plans FAQs regarding loans, for the loan limit, the five-year term, the payments, default, the plan loan offset and its rollover deadline.
- IRS, Retirement topics: tax on early distributions, for the additional 10% tax before age 59½.
- IRS, Retirement topics: exceptions to tax on early distributions, for the separation from service at age 55.