Before borrowing from 401(k) plans, be aware of actual cost

One of the "big advantages" of participating in your 401(k) plan is the ability to borrow money from the plan if you need to for any reason. You are able to borrow up to 50 percent of your vested account balance, with a maximum of $50,000.

This borrowing may seem like a great idea because you pay the interest back to your own account, and probably at a lower rate than a bank or other financial institution will charge you. However, there are many things to consider

After-tax dollars, lost earnings

The true cost of a 401(k) loan can be very high. The advantage of tax-deferred contributions is not available for loan re-payments. This means that when the time comes to pay back the money you borrowed from the plan, you can only use after-tax dollars.

Another drawback is the opportunity cost. Even though you are paying yourself interest, your return is limited to the amount the loan is charging. For example, if you borrowed from the plan at a rate of 6 percent, the maximum return that these monies can earn would be limited to 6 percent. You give up all the real earnings the borrowed money would have earned had it stayed in your plan.

You also run the risk of having an under-performing asset. Looking at the last two years, a 6 percent return seems very attractive. However, over long periods of time, high-quality stocks have outperformed "fixed" investments, such as loans.

When the best growth occurs, these circumstances could result in substantial lost earnings and reduce the eventual size of your retirement account.

Repayment

Another consideration is the repayment schedule. If you switch employers, you have two options: repay the entire balance or consider the outstanding balance an early plan withdrawal. If sufficient funds were available, you probably wouldn't have borrowed the money from the plan in the first place. Therefore, re-payment likely is not practical. But, if you treat the balance due as an early withdrawal, you will normally have to pay a 10 percent penalty in addition to regular income taxes.

The length of your repayment period also can pose a problem. At present, it is limited to five years, unless the loan is taken to fund the purchase of your principal residence.

Think long and hard before tapping your retirement assets to fund things other than your retirement. Research other loans that offer longer terms, such as home equity loans. These also will provide you with a more comfortable way to cover your unexpected expenses.

(Troy Kennedy is a senior vice president and shareholder with Spring-field Trust Company.)