The recent 401(k) FAQ at BankRate.com prompts me to put down this analysis about the real cost of borrowing from your 401(k) account. In my mind, the analysis for the second question in the BankRate article is very misleading, if not entirely wrong, in explaining how to evaluate the option of 401(k) loan.

The second question in the FAQ list is: "We have a great deal of credit card debt and are able to borrow from my husband's retirement to pay some of it off. The loan will be for only five years and will be repaid through a payroll deduction. Is this wise?"

To answer this question, the article first claimed that "[i]f you're in the 31 percent marginal federal income tax bracket, it will take $1.45 in wages or salary to replace each dollar you borrowed from the account -- plus interest."

This sentence is technically correct, but is an exaggeration of the real cost of 401(k) loan. It is unfair to use pre-tax dollars in this comparison. One can argue that saving one after-tax dollar really means saving $1.45 in pre-tax dollars when one is in the 31% tax bracket (see details in my prior post A Penny Saved is More Than A Penny Earned). However, it does not mean by taking one dollar less in the 401(k) loan you saved $1.45 in pre-tax dollars. Instead, if you take one dollar less in 401(k) loan, you will need one more after-tax dollar to pay off the credit card loan, and this means you need to earn $1.45 more in wages.

Second, to show as an example of how to compare a 401(k) loan with credit card loan, the author compares two scenarios: 8% APR 401(k) loan and 17% APR credit card loan, both at $25,000 and will be repaid in 60 months. Because the total payment in the 401(k) loan is $6,800 less than that in the credit card scenario, the author concluded that "[y]ou've saved almost $7,000 in interest expense" when you opt for the 401(k) loan option.

This time, the author underestimated the benefits of 401(k) loan. The $5,415 total interest payment in the 8% $25,000 401(k) loan scenario is actually paid to your own 401(k) account and will grow tax-deferred until your retirement. As a matter of fact, these $5,415 will need to be paid by after-tax dollars, and will become pre-tax dollars after the repayment, so the real cost of the interest payment is only $5,415 multiply by your tax bracket. If you are in the 25% group, the real cost of the interest payment is only $1,354. This will make you $10,900 better off choosing the 401(k) loan.

So, what's the real cost of the 401(k) loan? In my opinion, it's the 401(k) APR times your marginal tax rate. For example, if your 401(k) APR is 6% and your marginal tax rate is 25%, your real cost of the loan is 6% * 25% = 1.5%. And this is how I evaluate my cost of capital in my 401(k) loan for primary residence.

Another question is whether you should calculate the loss of opportunity cost when your 401(k) dollars can grow over time if you don't take the loan. My answer is no in most cases. Remember, taking the loan does not prohibit you earning a gain with the loan proceeds in your after-tax account.

As an example, assuming you take $5,000 401(k) loan and will pay back in one year. The 401(k) loan has an APR of 6% and the market can gain 10% for the year. Do you have any opportunity cost when you take out the loan? You will end up with $5,500 in your 401(k) account if you don't take the loan. You will end up with $5,300 in 401(k) account and $200 minus tax in after-tax account if you take the loan, invest the money at 10% rate, and pay off the 401(k) loan in one single shot at the end of the year. As long as you have not maxed out your 401(k) contribution limit (normally you should not if you are taking a 401(k) loan), you can still make even by moving $200 more to the 401(k) account.

To answer the original question in the FAQ, the simple answer should be: "the cost of 401(k) loan is your 401(k) loan APR times your marginal tax rate, and as long as it is less than the credit card APR, you'll be better off taking the loan and paying off the credit card debt."