I have read in the news lately that more and more people are tapping their 401(k) plans in order to get cash to pay bills. It doesn’t take a genius to figure out that in most cases, borrowing from your 401(k) is a bad idea. That said, I thought would be interesting to try to put some numbers to a 401(k) borrowing scenario to see how much a loan really costs.
With everything, borrowing from a 401(k) isn’t as simple as it seems. There are a lot of variables involved in trying to make a total cost estimate. For my example, I used the following assumptions:
1. Annual income of $80,000 or $3,333 twice per month (24 times per year).
2. 401(k) contributions of 10% per year before the loan was taken out.
3. A $10,000 401(k) loan is taken out on 12/15/2007 and paid back in equal installments over 48 months (96 payments total).
4. The 401(k) loan carries a 6% interest rate, making the AFTER-TAX payments $117.30 PER pay period.
5. Before-tax contributions to the 401(k) are reduced to 6.5% in order to keep the total amount of the after-tax loan payment ($117.30) and the before-tax contribution ($216.67) roughly equal to the previous before-tax contribution of $333.33 per pay period.
6. The 401(k) balance before the loan was $100,000.
7. The rate of return on the 401(k) is 8% per year or .33% per pay period. – I realize that straight-line appreciation isn’t the norm in the real world, but I had to factor in growth somehow.
8. For the income tax calculation I used 2008’s income tax brackets, standard deduction (for married filing jointly), and personal exemptions:
Wow! That’s a lot of assumptions! Now for the results:
According to my numbers, here’s what the situation would look like over the next four years:
So, assuming that over the next four years you didn’t get a raise and the tax rates didn’t change, you would pay roughly $1,700 more in taxes and your 401(k) account would be $14,000 smaller if you went with the $10,000 401(k) loan. The balance difference will grow significantly over the years due to compounding so it’s conceivalbe that the extra $14,000 could grow to over $140,000 over 30 years. That’s a significant difference!
The situation gets a lot better IF you can afford to pay back the 401(k) loan AND keep your contributions the same as they were before the loan:
Your 401(k) ending balance is down a bit but you don’t take a hit on your income taxes because your contribution levels stay the same, which keeps your taxable income the same.
The Bottom Line
So, how can you minimize the negative impact of a 401(k) loan?
1. For starters, don’t take out a loan if you don’t need it!
2. If you do need a loan, then take out the smallest amount possible for the shortest amount of time possible.
3. Try to keep your contributions at the same level during the loan payback as they were before the loan. This will keep your taxable income at the same level and keep you from having to pay more income tax.
4. Take out the loan right before a market decline! LOL! I’m joking on this one since it’s not feasible to time the market.
Any questions or thoughts? Did I miss anything? Leave a comment or shoot me an email and I’ll see if I can answer them.