What It Costs

The cost of borrowing from your retirement can be very complicated to determine. There are straightforward costs, such as a loan origination fee, which can be a one-time charge in the range of $100, then some plans charge maintenance fees which can tack on another $50 or so annually, (which would add up to about $250 over a five-year period). Then there is the cost of the interest you will be charged on the loan. This is often prime plus an additional percent or two. But remember that you pay the interest back to yourself, rather than the money going to an institution the way it would with conventional bank loan. This means that you be adding a little extra money to the balance throughout the repayment period. Just keep in mind that the amount of the interest you pay back often doesn’t equal the interest you might have earned on money if you had kept in your account in the first place.

There is also the cost of paying taxes on the loan. This is because your initial contributions into the fund were taken from your pay check without any taxes taken out of them. However, when you borrow from your balance and then repay it, the money you repay it with is taxed this time. This means that if 27 percent of your income goes to taxes, then for every $1 you take out of your retirement fund, it will cost you $1.40 to repay the same amount. Further, when you go to retire and pull money out of the account, the federal government will be taxing the money at that point. So you will in essence be paying taxes twice on the amount you borrowed, both now and again later.

Another important cost occurs when you pull money out of your fund, since you are losing the opportunity for the money to grow. This can be a significant loss, although it is hard to calculate since you don’t know what the actual rate of return would have been for that time period until it is paid back. In addition, if you are prohibited from making contributions during this period, that is more lost growth and also lost employer match, so this adds up, too.

So the cost of a borrowing from your retirement account for five years includes:

• About $350 in plan fees.
• Interest on the amount of the loan at about prime plus one or two percent.
• Double-taxes on the loan amount (since repayments are taken from post-tax dollars, and you will also pay interest on the amount again when you withdraw it in retirement.)
• Lost interest on the money, plus the loss of it compounding.
• Loss of your employer match while you are repaying the loan amount.

Other Taxes And Penalties

If you are unable to pay back the amount you borrow in the timeframe designated by your plan, then the loan will be treated as an early withdrawal. This will even further increase the costs. You will be responsible for a 10 percent penalty, plus you will be taxed on the money at your normal income tax rate (such as 27.5 percent). If your taxes and penalties add up to almost 40 percent, this means that a $2,000 loan will only leave you with about $1,200. That’s a significant difference, especially when you consider the fact that the original $2,000 would have grown to be a lot more over time.

Other Options

Before taking money from your retirement account, the experts suggest considering other options if possible that could be more feasible and have less of an impact on your retirement savings down the road. You may want to look into the terms of a bank or home equity loan and weigh the pros and cons of each to see what makes the most sense.

A Final Note

Remember that retirement plans all have different terms, so you will want to find out exactly what is involved for your specific situation. Always consult with a financial planner for advice before making any decisions. You can also visit the IRS website for federal rules and regulations.