The Hidden Cost of Taking a 401(k) Loan: Borrower's Remorse

In a financial emergency, borrowing from your 401(k) plan seems like an obvious step—and given the tough economy, many people are doing just that. But a new survey finds a surprising number of people are tapping their retirement nest eggs for frivolous spending. And they're later regretting it.

Nearly one-third of Americans say they have taken a loan from their retirement plan, according to a study by TIAA-CREF, a retirement plan administrator. Many borrowed for urgent reasons: 46% used the money to pay off debt and 35% cited a financial emergency. But a significant percentage of 401(k) savers are using their nest eggs for non-emergencies: 25% report borrowing for a home purchase or renovations, while 15% use the money to pay for weddings and vacations.

With so many depleting their nest eggs for trips to Cancun or lavish floral arrangements, it's not that surprising that half of borrowers surveyed now say they regret taking out the loan. “People still look as their 401k as an emergency savings fund, not just a retirement plan,” says Rick Meigs, president of the 401k Help Center. “When it comes to a cruise or a vacation, you shouldn’t be borrowing for it in any way, let alone from your retirement funds.”

If you do face a true financial crisis, it’s not necessarily a bad decision to take a loan from your retirement plan, says Meigs. For one thing, 401(k) borrowing is cheaper than most bank loans or credit card rates. Typically you'll pay one or two percentage points above the prime rate, which is 3.25% currently. Plus, you pay the interest back to yourself. There are few restrictions on borrowing—you can generally take out no more than 50% of your account value up to $50,000. (You can find more details about 401(k) loans here.)

But borrowing against your plan has serious drawbacks. Chief among them: If you lose or quit your job, you must repay the loan in full within 60 days or you’ll be hit with a 10% penalty and income taxes. That trips many people up: More than 80% of workers who left their jobs with a 401(k) loan defaulted, according to the Financial Literacy Center, a joint project by the RAND Corporation, Dartmouth College and the Wharton School. Overall, one out of 10 401(k) loans are not repaid, according to a recent Pension Research Council study, which found such defaults averaged $6 billion annually.

Then there are the costs to your retirement security. More than half of borrowers accounts decreased the amount they’re contributing to their 401(k) while repaying the loan, the survey found. You can’t make up the contributions you lost. What's more, the money you use to repay the loan ends up being taxed twice—you will be putting in after-tax dollars, which will be taxed again when you take withdrawals at retirement. (To see how a loan might slow the growth of your 401(k) account, consider this explanation from Fidelity.)

“The point of your retirement account is to provide money when you’re no longer earning a pay check,” says Sean Donald Wilson, a wealth advisor at TIAA-CREF. “When you borrow from it, you’re removing money that could be growing for your future needs.”

Concerns over 401(k) borrowing have led some retirement plan experts to recommend more restrictions on loans. That's not likely to happen anytime soon, however. So put those restrictions on yourself, and avoid tapping your 401(k) until you reach retirement.