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When a 401(k) Loan Makes Sense

401(k) Loan The basics

The 4 most compelling reasons to borrow

Stock Market Myths

Debuting Myths With Facts

401(k) loans to purchase a Home

The Bottom Line

Retirement Plan 401(k)

4 Reasons to Borrow From Your 401(k)

When is the best time to get an 401(k) loan? If the market is down

By Troy Segal

Updated January 25, 2022

Reviewed by David Kindness

Fact checked by Skylar Clarine

Skylar Clarine

The financial media has coined some negative terms to explain the dangers that come with borrowing from the 401(k) program. Some, including financial planners, would claim that taking a loan from a 401(k) scheme is an act of theft against your retirement.

However, it is true that a 401(k) loan can be appropriate in some situations. Let’s take a look at how such the loan could be used sensibly and also why it shouldn’t spell trouble in your financial savings.

The most important takeaways

If done with the good reasons, taking out an immediate 401(k) loan and paying the loan back on time doesn’t mean it’s a terrible option.

Some of the reasons to borrow from the funds in your 401(k) include convenience and speed and flexibility in repayment along with cost advantages and potential advantages to your retirement savings in a declining market.

Common arguments against taking loans loan can be a negative impact on performance in the investment market, tax efficiency and the fact that quitting a job with unpaid loan will have undesirable consequences.

A depressed stock market could be one of the best times to take a 401(k) loan.

If you need a 401(k) loan is a good idea, it makes sense.

When you must find the funds for a critical short-term liquidity need then a loan from the 401(k) plan is likely to be the first place you should look. Let’s define short-term as being at least a year. It is possible to define “serious liquidity need” as a serious single demand for money or a lump-sum cash payment.

Kathryn B. Hauer, MBA, CFP(r), a financial planner with Wilson David Investment Advisors and the author of Financial Tips to Blue Collar America explained it as follows: “Let’s face it, in the real world, sometimes people require cash. The borrowing option out of your 401(k) can be economically smarter as opposed to taking out a hefty high-interest title loan or pawn or payday loans, or even a more reasonable personal loan. It’s less expensive in the long term. “1

What makes your 401(k) an excellent source of short-term loans? It’s because it’s the fastest, most simple, cost-effective way to obtain the money you require. Receiving a loan through your 401(k) isn’t tax-deductible, unless the loan restrictions and repayment guidelines are not followed, and it will not impact your credit score.

Assuming you pay back an unrepayable loan in a timely manner, it usually won’t have any impact on your retirement savings progress. In fact, in some instances, it could be beneficial. Let’s look a bit deeper to understand the reasons.

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Image of Sabrina Jiang (c) Investopedia 2020

401(k) Basics of Loans

Technically, 401(k) loans are not real loans as they don’t require an appraisal by a bank or a review of your credit background. They can be defined as being able to access a portion of your own retirement plan money–usually up to $50,000 or 50% of the funds, or lower, on an untaxed basis.2 You must then pay back the funds you accessed under rules that are designed to bring the condition of your 401(k) plan to approximately the same condition like if the transaction has not taken place.

Another confounding aspect of these transactions is the term interest. Any interest charged on the unpaid loan balance is paid back by the borrower into the participant’s 401(k) account. So, technically, this also is an exchange from one of your pockets to another, and not a borrowing expense or loss. As such, the cost of the 401(k) loan on your savings in retirement can be low, neutral, and even positive. In most cases, it’ll be lower than paying interest on a personal or commercial loan.

How to Become a 401(k) Millionaire

The Top 4 Reasons to Borrow From Your 401(k)

The top four reasons to turn at your 401(k) for serious short-term cash needs are:

1. Speed and Convenience

In most 401(k) plans, requesting an loan is simple and quick with no long applications or credit checks. Normally, it does not generate an inquiry against your credit score or impact the credit rating.

A lot of 401(k)s permit loan requests to be made by only a couple of clicks on the website and funds could be in your hand in several days, while maintaining absolute security. One new feature that is being used by certain plans is a debit card with which multiple loans can be made instantly in smaller amounts.3

2. Repayment Flexibility

Although the regulations stipulate the amortization schedule for five years, for most 401(k) loans, you are able to repay the loan sooner and with no prior payment penalty.2 The majority of plans permit loan payment to be made easily through payroll deductions using tax-free dollars, but not pretax funds that are credited to your plan. The statements of your plan show credit for your loan account and your resting principal balance exactly like a typical bank loan statement.

3. Cost Advantage

There’s no cost (other than perhaps a modest loan administrative or origination cost) to draw on your own 401(k) money for short-term liquidity needs. Here’s how it usually works:

You select an investment account(s) from where you wish to borrow money. the investments are liquidated for the duration of the loan. So, you forfeit any positive earnings that would have been produced by those investments over a brief period. If the market is in decline, you are selling the investments at a lower price than at other times. It’s a good thing because you will not suffer any additional investment losses from this money.

The benefit of the 401(k) loan is the equivalent of the rate charged on the same consumer loan plus any capital gains from the principal loan you took. Here is a simple formula:

Cost Advantage = Cost of Consumer Loan Interest -Lost Investment EarningsCost Advantage = Cost of Consumer Loan Interest and Lost Investment Earnings

Let’s say you could apply for a personal loan or get a cash advance using a credit card at an interest rate of 8. The 401(k) portfolio is generating an annual return of 5. Your cost advantage for taking out loans from your 401(k) plan would be 3% (8 – 5 equals 3).

Whenever you can estimate that the benefit from cost will be positive in the long run, a plan loan could be appealing. Keep in mind that this calculation does not take into account the tax implications, which can increase the plan loan’s advantage because consumers loan interest is paid back with tax-free dollars.

4. Retirement Savings Can Benefit

If you make loan payments to your 401(k) account, they usually are allocated back to the portfolio’s investments. You will repay the account in a little more than the amount the amount you borrowed, and this difference is known as “interest.” The loan has no (that is, neutral) effect on retirement plan if loss in investment earnings are equal to the “interest” that you pay in–i.e. the earnings potential are offset dollar-for-dollar with interest payments.

If the interest paid exceeds the lost investment earnings taking out a 401(k) loan can actually boost your savings for retirement. Keep in mind however that this will proportionally reduce savings for your own (non-retirement) saving.

Stock Market Myths

The above discussion prompts us to discuss a different (erroneous) claim about 401(k) loans: By withdrawing funds, you’ll drastically hinder the performance of your portfolio and the building up of your retirement nest egg. That’s not necessarily true. In the first place, as mentioned above, you will have to repay the funds and you begin doing it fairly soon. Given the long-term horizon of the majority 401(k)s, it’s a pretty small (and financial insignificant) interval.4

19%

The proportion of 401(k) participants who had outstanding loans in 2016, (latest information), according to a study by the Employee Benefit Research Institute.5

The other problem with the bad-impact-on-investments reasoning: It tends to assume the same rate of return over the years and–as recent events have made stunningly clear–the stock market doesn’t work like that. A portfolio that is geared towards growth and oriented towards equities is likely to experience ups and downs, especially in the short term.

When you have a 401(k) is comprised of stocks, the true impact on the short-term loans on your retirement plan will be contingent on the current market conditions. The impact should be modestly negative in up markets that are strong, and it can be neutral or positive, in sideways or down markets.

The good and bad news: the best time to apply for the loan will be when feel the market is in danger or weakening, for instance during recessions. Coincidentally, many people find that they need funds or to stay liquid in these periods.

Debuting Myths With Facts

There are two more common arguments against 401(k) loans: The loans aren’t tax efficient and they create enormous headaches when participants can’t pay them back before they retire or leave work. Let’s dispel these myths by presenting facts:

Tax Inefficiency

The argument is that 401(k) loans are tax-inefficient because they must be repaid using tax-free dollars after tax, thereby exposing loan repayment to taxation double. Only the part of the repayment that is financed by interest is subject to this treatment. Media often do not mention that the price of double taxation of loan interest is often fairly small, compared with the cost of other methods to access short-term liquidity.

Here is a hypothetical situation that is too often very real: Let’s say Jane is able to make steady savings by deferring 7percent of her earnings in her 401(k). But, she’ll require a withdrawal of $10,000 to pay for a college tuition bill. She expects to pay this loan back with her earnings in around one year. She is in a 20% federal and state tax bracket. Three ways she can tap the cash:

Borrow from her 401(k) with an “interest amount” of 4.4%. The cost of taxing double on the interest amount is 80 dollars ($10,000 loan x 4% interest plus 20 percent taxes).

Borrow from the bank at a rate of real interest of 8.8%. The interest rate is $800.

Stop making 401(k) plans deferrals over the course of a year, and use the money to pay her tuition at college. In this situation, she will lose real savings from retirement, have to pay higher current income tax, and potentially be unable to receive any employer-matching contributions. The cost could easily be up to $1,000.

Taxation on double taxation for 401(k) loan interest becomes a meaningful cost only when huge amount are borrowed and paid back over a long period of time. However, even then, it typically is less expensive than other options for getting similar cash via bank or consumer loans or a pause in deferrals from the plan.

Working and leaving with an unpaid Credit

Suppose you take a plan loan and you lose your job. You will have to repay the loan in the full amount. If you fail to do so then the total remaining loan balance will be considered a tax-deductible distribution and you may also be subject to a 10% federal tax penalty for the balance that is not paid when you’re under the age of 59 1/2 .6 Although this may be an accurate representation of the tax laws, it may not necessarily reflect the reality.

At retirement or separation from employment, many people often decide to use a portion of their 401(k) funds as a tax-deductible distribution, especially if they are cash-strapped. A unpaid loan balance can have similar tax consequences to the decision. The majority of plans don’t require distributions at retirement or retirement from service.

Individuals who wish to avoid tax penalties can use other sources to repay the 401(k) loans before taking an income distribution. If they do so, the full plan balance can qualify for a tax-advantaged rollover or transfer. If an outstanding loan balance is included in the participant’s tax-deductible income, and the loan is then repaid the penalty of 10% does not apply.7

The bigger issue is taking 401(k) loans while working but not having the intention or capacity to pay them in a timely manner. In this scenario the not paid loan amount is treated similar to a hardship withdrawal with negative tax consequences and possibly an adverse impact on plan participation rights.

401(k) Credits to Purchase the Home of your choice

Regulations make it mandatory for 401(k) plan loans to be repaid using an interest-based basis (that is that, with a fixed repayment plan in regular installments) for a minimum of five years, unless it is the case that the loan is used to purchase the primary residence. Payback times that are longer are permitted for these specific loans. The IRS does not provide a timeframe for the loan, though, so it’s something you’ll need to discuss with the plan’s administrator. And ask whether you get an additional year due to the Cares bill.2

Also, keep in mind that CARES increased the amount that participants can take out of their plans up to $100,000. Prior to this, the maximum amount that participants could borrow from their plan is 50 percent of the balance of their vested account (or $50,000), whichever amount is less. If the vested account balance is less than $10,000, you may still be able to borrow $10,000.2

Borrowing from the 401(k) to finance completely the purchase of a home isn’t as attractive as taking out a mortgage loan. Plan loans do not offer tax deductions for interest payment unlike the majority of mortgages. And, while taking out and paying back your loan within five years is acceptable under the normal rules that is 401(k) things but the impact on your retirement progress for the loan that has to be paid back over a number of years can be significant.

However, a 401(k) loan might work well if you need immediate funds to pay for the closing costs of a house. It won’t impact your ability to qualify for a mortgage either. Since the 401(k) loan isn’t technically an obligation–you’re taking out your own money and, in the end, it has no effect on your debt-to-income ratio or on your credit score, which are two of the major elements that affect lenders.

If you are in need of the money to buy a house and want to utilize 401(k) funds it is possible to consider a hardship withdrawal instead of, or in addition to the loan. You will be required to pay income tax on the withdrawal and, if the amount is greater than $10,000, a 10% penalty will be imposed as well.7

The Bottom Line

The argument about 401(k) loans “rob” or “raid” retirement accounts often contain two flaws: They assume constantly strong stock market returns in the 401(k) portfolio but don’t take into account the costs of borrowing similar amounts from the bank or other loans (such as accruing the balance of credit cards).

Don’t be scared away from the possibility of a beneficial liquidity option in the 401(k) plan. If you are able to borrow the right amounts of money for the most appropriate reasons in the short term, these transactions can be the most simple, efficient, and least expensive option for cash. Before you take any loan it is essential to be prepared in your mind for repaying these amounts in a timely manner or sooner.

Mike Loo, vice president of wealth management at Trilogy Financial, puts it this way “While your circumstances when taking the 401(k) loan may vary however, one way to prevent the risks of taking one at all is to take preventive measures. If you can take the time to preplan, set goals for your financial future and set a goal to save some of your money both often and at an early time You may discover that you have the money in a different account from your 401(k) and thereby avoiding the necessity of taking the 401(k) loan.”