According to a study by the Employee Benefits Research Institute (EBRI), nearly 20% of all 401(k) participants had plan loans outstanding. This statistic has held true since the early 2000s. These loans can be appropriate in some situations. However, borrowing from a 401(k) plan exacts a big opportunity cost. Let’s first look at what borrowing from a 401(k) plan means and how it works.
Technically, 401(k) loans are more accurately described as the ability to access a portion of retirement plan money on a tax-free basis. A borrower then must repay the money accessed to restore the 401(k) plan to its original state.
Borrowers specify the investment account(s) from which to borrow money. Those investments are liquidated for the duration of the loan.
As loan repayments are made to the 401(k) account, they usually are allocated back into the investments originally chosen. The account is repaid more than what was borrowed from it, and the difference is called interest.
Any interest charged on the outstanding loan balance is repaid by the participant into the participant’s own 401(k) account, so technically this is a transfer from one pocket to another, not a borrowing cost.
Regulations specify a five-year amortizing repayment schedule. Repayment plan statements show credits to the loan account and remaining principal balance, just like a regular bank loan statement.
If a 401(k) is invested in stocks, the impact of the loan on retirement progress depends on the market environment.