Thinking about taking a loan from your 401(k)?
You owe the whole amount, NOW
Burried in the details of 401(k) loans, is that 401(k) plans require you to pay back your loan IN FULL within 90 days (or less) of your termination of employment. So, whether you quit because you finally got your dream job, or because you want to start your own business, or because you get laid off, or merged, or bought out, or retired, you owe the WHOLE BALANCE in 90 days. What happens if you don't pay? Well, then, it counts as a withdrawl. If you aren't 59 1/2 yet, that means you owe the taxes plus a 10% penalty.
Ready for the ugly math? Let's say you take $20,000 to remodel your home. It's a good investment right? Then, let's say that you keep your job and spend the next 16 months paying it back at the rate of $200 per month (that's right, it's still a loan, so you are making payments.) Not including interest (yes, you pay interest), you've paid back just $3,200 so you still owe $16,800.
Now, let's say your best friend from college offers you a dream job with his company. When you quit, you will owe $16,800 all at once. If you had that much lying around, then you probably wouldn't have taken the loan in the first place. So, you can either go find another loan as fast as you can, or you are going to get dinged by the IRS.
That $16,800 gets added to your income. (Are you in a higher tax bracket now?) Just for easy math let's say you are in the 20% bracket. That means you owe an extra $3,360 on your taxes in April, plus a ten percent penalty of $1,680 for a total hit of $5,040. That is over 20% of your original loan! Where will you get the $5,000? Don't even think of getting if from your 401(k) or that is ANOTHER distribution and another penalty.
Paying Interest to Yourself - The Myth That Costs You Forever
Somewhere along the way, someone who doesn't know very much about how money, investing, and retirement work decided that a 401(k) loan was a good thing because you were paying the interest to yourself.
This logic is terribly flawed and yet, I hear it every month from someone, usually people who are very smart. To see the issue, take a look at this example:
Bob has $100,000 in his 401(k) account. He takes a $20,000 loan from his 401(k). He has a good plan that allows him to take the loan at just 5% and allows him his choice of repayment plans: 5 years, 10 years, or 20 years. Bob chooses the 10 year plan which means he owes $212.13 per month for the next 10 years. The 5% that he pays himself does indeed go into his account. So his 401(k) account now has $80,000 and he'll get the usual return on that money plus the loan payments.
Now, if Bob's 401(k) account earns only 5% per year of the next 10 years, then Bob will have basically the same amount of money either way, approximately $163,000. The difference is that without the loan, all of that $63,000 is "free money", or returns from the markets. In contrast, with the loan, more than $25,000 came from Bob's money (His $212.13 payment * 120 payments). Only, $42,000 is "free money".
Of course, if Bob has a decent diversified portfolio that he manages properly, he should get at least 8% even if his is being conservative. 9% is very likely over a 10 year period. At 8% Bob's 401(k) has grown to almost $216,000 without the loan. With the loan only $80,000 grows at 8% the rest grows at just 5%. So Bob's non-loan part ends up at around $173,000 while the loan re-payments still end up around $25,000. So not only does Bob not get as much "free money," he just flat out ends up with less money, around $10,000 to $15,000 less (This is the "easy math" version; you would have to figure how long each of Bob's loan payments earned the higher rate to get a number, but that's more work that its worth for an example.)
If you really want to see the sting, look at it this way. If Bob has an extra $200 laying around each month (he better, he's going to need it to make that loan payment), maybe he should invest it. If Bob invested that $200 a month and mananged to get just a 6% after-tax return, he would have almost $35,000 at the end of the 10 years. So take the non-loan 401(k) amount of $216,000 and add this extra $35,000 and Bob ends up with $250K instead of barely $200K.
At this point, someone will always bring up the fact that if they took the loan from somewhere besides their 401(k) that they would have to make the payments anyway and then the numbers aren't so bad. This is true, but too many people take a false comfort in taking a 401(k) loan. I would bet that at least half the people who take 401(k) loans would not take out a loan at all if they had to get a home equity loan instead. I would further bet that 90% of people who can't get a home equity loan (not enough equity) would take out a personal loan (at 12% or higher) if they couldn't take a loan from their 401(k). If you are going to take out a loan one way or another, the math doesn't look as bad, but keep this in mind. The better the market does while you are repaying your loan, the worse the math gets for you. Also, keep in mind that the full repayment clause still applies to you. A home equity loan doesn't care if you change jobs, you still have the full 10 years to repay. Not so with your 401(k) loan.