Half of all U.S. workers participate in their employer's retirement plan. About 14% of those with 401(k)s borrow money from them. Understanding 401(k) loans is important both for those who already have a loan and those who are contemplating getting one. 

Borrowing Limits

According to the IRS, you can borrow up to 50% of your vested 401(k) balance, or $50,000, whichever is less. If your vested balance is less than $20,000, you can borrow any amount up to $10,000. Vested means you own it; for employer matching funds that can take up to five years. You are immediately vested in all funds that you put into the plan.

Interest Payments

One of the unique features of a 401(k) loan is that you pay interest to yourself. Normally when you borrow money such as a home mortgage or an auto loan, the interest is paid to the lender. When you borrow money from your 401(k), you are the lender. All interest paid comes right back to you and goes into your 401(k) account. Awesome, right? Not so fast.

Opportunity Cost

In the financial world there is a concept known as opportunity cost. Opportunity cost is the loss of potential gain when one alternative is chosen over another. In other words, it's what you would have received had you done something other than what you did. For example, if back in the year 2000 you bought a carton of cigarettes instead of investing the money in Amazon, the opportunity cost is $1,600. 

What? That can't be right. A carton of cigarettes today is about $75; adjusted for 2% annual inflation in 2000 it cost $50. In 2000 one share of Amazon stock cost $100. Today it is worth $3,200. $3,200 ÷ 100 = 32 x $50 = $1,600. It's right.

When you borrow money from your 401(k), the opportunity cost is the investment return you would have earned had you left the money where it was. Over time, investment earnings become earnings on earnings or compound interest – something Albert Einstein dubbed the 8th wonder of the world.

For the period of time that the loan is outstanding, which can be up to five years, the loan balance earns no return. That means if the stock market doubles like it has since March of last year, you get nothing.

Loan Payments

Another consideration with 401(k) loans is the fact that loan payments act as a headwind to continued plan contributions. When you get a loan, it's usually because you need money. That being the case, it stands to reason that you may not have the means to make the loans payments and continue making plan contributions. It's one or the other, and since there are substantial penalties for defaulting on the loan, the loan payment gets the nod. 

For the life of the loan, you are not only forgoing investment earnings but contributions as well. When you don't make contributions guess what happens to the employer match? There isn't one. No investment earnings, no contributions, and no employer match. That's a triple whammy that could be a knockout blow. But wait, there's more.

Double Taxation

When you contribute to your 401(k), you do so with pre-tax dollars. The money gets taken out of your paycheck and placed into your 401(k) and it doesn't show up on your W2. Instead, you pay taxes on funds contributed to a 401(k) when you withdraw them in retirement.

When you repay a 401(k) loan, you do so with after-tax dollars. Those dollars do show up on your W2 and you pay tax on them in the year they were earned. Here's the rub: when you withdraw money from your 401(k) in retirement, the IRS makes no distinction between pre-tax dollars used for regular 401(k) contributions and after-tax dollars used to repay 401(k) loans. As a result, all funds used to repay 401(k) loans are double taxed – once on the way in for loan repayment and again on the way out in retirement withdrawals. That's what you sign up for when you get a 401(k) loan.

Conclusion

A 401(k) loan is a bad idea. Not only does it do significant harm to your retirement savings, it places you at risk for a significant financial event. In the fine print that no one bothers to read, all 401(k) loans require you to repay the loan in full before your next tax return in the event that you lose your job. Think about it. You took out the loan because you needed money, now you've lost your job and have no income, and on top of that you're faced with a repayment deadline you have no chance of meeting.

If you need the money for a legitimate emergency, consider getting a hardship withdrawal. Eligible 401(k) hardship withdrawals include medical expenses, funeral costs, and funds required to prevent foreclosure or eviction.

Photo credit: Mike Ballew The Eggstack Blog will never post an article influenced by an outside company or advertiser. Our mission is to help you overcome uncertainty about retirement planning and inspire confidence in your financial future.