Participating in the company’s retirement plan is a smart and important decision! Smart because you are putting away small amounts today for a comfortable retirement later.
As your account begins to grow, it may be tempting to “dip into” your retirement savings by taking a loan against your retirement plan to pay your annual taxes, repair a leaking roof, catch up your everyday pile of bills, and so on. While the decision to take a plan loan is yours to make, we want to make sure that you consider what it will really cost.
With a retirement plan loan, you pay yourself back the amount plus interest. But the true cost can be harder to see:
- You are double-taxed on repayments: once when you repay the loan with after-tax dollars and again when you withdrawal money in retirement.
- Your money is no longer invested, so you lose the opportunity for investment earnings and the compounding of those earnings.
- There is (typically) an initial set-up and quarterly loan fee.
- Most employees decrease or cease the amount they are contributing to compensate for the loan repayment.
To further illustrate the costliness of taking a plan loan, consider the following hypothetical example*:
Jane took a $10,000 loan at 7% interest from her retirement account; her account balance before the loan was $20,000. She previously made contributions of $150 per paycheck (including the employer match). Because she had to repay the loan, she decreased her future contributions to $50. Additionally, prior to the loan, she was earning a 10% return. She will repay the loan over five years.
If you consider loss of interest, compounding, and tax on repayments, the actual retirement plan loan is costing Jane 13.77%! And don’t forget about those decreased contributions, which can add up to hundreds of thousands of dollars over many years.