The Real Cost of Loans

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The Real Cost of Loans

What employers and employee need to know about borrowing from workplace retirement plans

Ashley Patrick and her husband, both in their late twenties, took out a $25,000 loan from his 401(k) account to pay for a home renovation. Then he lost his job, which triggered mandatory full repayment within 90 days. They didn’t have the cash to pay off the loan, so the IRS treated it as an unqualified distribution subject to income tax and penalties. Today Ashley says they were naive about the loan; she estimates that if they’d left that money in the 401(k) account, it would have grown to about $1 million by retirement.

Ashley and her husband aren’t alone. Many employees are tempted to borrow from their workplace retirement plans. At year-end 2016, 19% of all workplace retirement participants who were eligible for loans had loans outstanding against their 401(k) plan accounts. The outstanding loans amounted to 11% of the remaining account balance on average.

People commonly take loans from their retirement plans to pay for a down payment on a house, a wedding, a lifestyle upgrade like a new car or college. But loan-eligible employees may not understand the true cost of borrowing against their nest eggs. Says Ashley: “I thought the 401(k) was collateral — I didn’t realize they actually took the money out. That was the first shock.”

The real cost of a workplace retirement plan loan

Retirement-plan loans include several predictable costs:

  • Loans carry an origination fee, typically more than $75. This is a fixed cost, not a percentage of the loan.
  • The interest rate on these loans is usually one to two percentage points above prime rate. Loan payments (made through payroll deduction) include principal and interest, all of which are paid by the borrower back into their own account. These payments are intended to help offset missed investment growth from the borrowed money.
  • Money borrowed from a workplace retirement plan account is repaid with after-tax money, and retirement withdrawals of those repayments will again be taxed as income. Put another way, borrowers lose tax deferral on any cash they borrow from their plans.
  • Since loans reduce the amount of money in the plan that can take advantage of tax-deferred growth, borrowers face diminished power of compounding. The length of time until retirement contributes to the opportunity cost of the lost compounding. Moreover, in a bull market the interest paid on the loan is unlikely to offset the missed investment return.

Workplace retirement plan borrowers also may encounter some other costs:

  • Most plans call for immediate repayment (typically within 60-90 days) of the full loan balance if an employee leaves their job for any reason. This requirement relieves employers of the responsibility to administer loan payments for ex-employees, but it can create a hardship for workers who are terminated unexpectedly. About 10% of borrowers default on their loans on average. Some plans allow for installment repayment after separation — but with no automatic payroll deduction, the ex-worker is still a default risk.

As Ashley Patrick and her husband learned, a defaulted loan is treated like an unqualified distribution, so it triggers a 10% penalty as well as tax on the unpaid balance. “We went from getting a $4,000 tax refund to owing the IRS $10,000,” she says. The cost of the tax and penalty was fully half the loan balance. “I was freaking out. I couldn’t sleep. I didn’t know how we were going to pay it.”

  • In many cases, workers who borrow from their workplace retirement plan accounts stop regular contributions in order to pay back their loans. Some employer plans do not allow contributions during a loan repayment period. The suspension of contributions — and any forgone employer match they would have triggered — creates yet another opportunity cost.

Implications for employers and advisors

Most plans let workers borrow against their nest eggs. Such loans can be prudent if employees pay them off on time and continue to make regular plan contributions — especially if a loan enables a worker to invest in a home. Loans can be costly when employees don’t keep making contributions, and they can be especially problematic in the event employees lose or leave their jobs.

Employers and advisors should consider educating employees about the risks of taking loans from their workplace retirement plan accounts. They also can help employees calculate the savings gaps they could face as a result of borrowing from their long-term savings. Education should focus on:

  • The cost of taking a loan for a younger worker compared with an older worker.
  • The gap created by stopping regular plan contributions and foregoing the employer match.
  • How to manage repayment in the event of job separation.

To pay off their IRS debt after defaulting on the loan payback, Ashley and her husband used a debt repayment plan and a zero-interest 18-month credit card. They could have done the same to pay off the loan itself within the 90- day deadline and avoided the income tax and penalties — but they didn’t understand those implications at the time. In hindsight, Ashley says, “I wouldn’t have taken the loan at all. I would have either not done the home renovation right away or figured out some other way to pay for it.”

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Patty Dickerson

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