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If you need a 401(k) Loan is the right choice,

401(k) Loan Basics

The Top 4 Reasons to Borrow

Stock Market Myths

Debuting Myths With Facts

401(k) loans to purchase a Home

The Bottom Line

Retirement Planning 401(k)

4 Reasons to Borrow from Your 401(k)

The best time to take a 401(k) loan? If the market is down

By Troy Segal

Updated 25 January 2022

Review by David Kindness

Fact checked by Skylar Clarine

Skylar Clarine

The financial press has come up with a few pejorative words to highlight the risks that come with borrowing from the 401(k) scheme. Some–including financial planning professionals–would even have you believe that taking out a loan from the 401(k) program is an act of fraud committed to derail your retirement.

But a 401(k) loan can be appropriate in some situations. Let’s take a look at how such a loan could be used sensibly and how it doesn’t spell trouble to your savings for retirement.

The most important takeaways

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

The reasons to take out a loan from the funds in your 401(k) include the speed and convenience, repayment flexibility as well as cost savings, and potential advantages for your savings in a declining market.

The most common arguments against taking out loans loan can be a negative impact on the performance of investments, tax inefficiency, and that leaving work with unpaid loan can have unintended results.

A down market for stocks could be among the most favorable times to apply for a 401(k) loan.

When a 401(k) Loan is the right choice,

If you need to find cash for a serious short-term liquidity need the loan taken from your 401(k) plan could be the first place to look. We’ll define “short-term” as approximately a year or less. Let’s define “serious liquidity need” as a significant one-time need for funds or a lump sum cash payment.

Kathryn B. Hauer, MBA, CFP(r), a financial planner at Wilson David Investment Advisors and the author of Financial Advice for Blue Collar America put it as follows: “Let’s face it, in the real world, there are times when people need money. In fact, borrowing out of your 401(k) can be more financially prudent then taking out a cripplingly high-interest title loan or pawn payday loan, or even a affordable personal loan. It will cost you less in the long run. “1

What makes your 401(k) an attractive source for short-term loans? It’s because it’s the most efficient, simple, and cost-effective way to obtain the money you require. The receipt of a loan through your 401(k) isn’t tax-deductible, unless the loan restrictions and repayment guidelines are not followed, and it does not affect your credit rating.

If you are able to repay the short-term loan on schedule generally, it will have little effect on your retirement savings progress. In fact, in some circumstances, it may be beneficial. Let’s look a bit deeper to explain the reasons.

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Image taken by Sabrina Jiang (c) Investopedia 2020

401(k) Loan Basics

Technically, 401(k) loans are not true loans as they don’t involve the involvement of a lender, or an assessment of your credit history. They can be described as having the capability to gain access to a certain amount of your own retirement plan money–usually as much as 50% or $50,000 of the assets, whichever is lower, on an tax-free basis.2 You must then repay the money you have access to under rules that are that are designed to restore the condition of your 401(k) plan to its original state in the same way as if the transaction had been unintentional.

Another confounding aspect of these transactions is interest. The interest that is charged on the remaining loan amount is paid by the participant to the participant’s own 401(k) account, which means that technically, this also is a transfer from one of your pockets to another, and not an expense for borrowing or loss. This means that the cost of the 401(k) loan on your savings in retirement can be low, neutral, in some cases even positive. However, in the majority of cases, it will be lower than paying interest on a consumer or bank loan.

How to Become a 401(k) Millionaire

The Top 4 Benefits of Borrowing From Your 401(k)

The top four reasons to look to your 401(k) for serious cash-flow needs in the short term are:

1. Speed and Convenience

In most 401(k) plan, applying for the loan is easy and fast and does not require lengthy requests and credit check. Normally, it does not cause an inquiry to your credit or affect the credit rating.

Many 401(k)s permit loan applications to be made by only a couple of clicks on a website, and funds could be available in a few days, with absolute security. One new feature that is being used by certain plans is a debit card through which multiple loans can be made immediately in tiny amounts.3

2. Repayment Flexibility

While regulations require an amortizing five-year repayment plan in the case of most 401(k) loans, you can pay back the loan quicker and without a penalty for prepayment penalty.2 Most plans allow loan repayment to be done easily through payroll deductions using tax-free dollars, but not the pretax ones funding your plan. Your plan statements show credits for your loan account as well as your outstanding principal balance just as a normal bank loan statement.

3. Cost Advantage

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

You specify your investment account(s) from which you’d like to borrow money, and the investments are liquidated for the duration that you loan. This means that you will lose any earnings that could have been produced by those investments for a short period. If the market is down then you will be selling these investments for less than at other times. The benefit is that you also avoid any additional investment losses from this money.

The cost benefit of the 401(k) loan is the equivalent of the interest rate on a comparable consumer loan less any loss of capital gains on the principal you borrowed. Here is a simple formula:

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

Let’s say you could take out a bank personal loan or take a cash advance with credit card at an interest rate of 8. You’re 401(k) portfolio is generating a 5% return. Your benefit from using the 401(k) plan is 3percent (8 – 5 equals 3).

If you are able to estimate that the cost advantage is positive in the long run, an option for a plan loan could be appealing. Be aware that this calculation does not take into account any tax impact that could increase the plan loan’s advantage because the consumer loan interest is repaid with after-tax dollars.

4. Retirement Savings Can Benefit

As you make loan repayments towards your 401(k) account generally, they will be remitted back to the portfolio’s investments. You’ll have to repay the account a bit more than you borrowed from it, and this is referred to as “interest.” The loan has no (that is, neutral) impact on your retirement, if lost investment earnings match the “interest” that you pay in–i.e., earnings opportunities are offset by interest payments.

If the amount of interest you pay is greater than the lost investment earnings, taking an 401(k) loan can actually increase your retirement savings progress. Remember however that this will proportionally lower your personal (non-retirement) saving.

Stock Market Myths

The above discussion leads us to address another (erroneous) assertion about 401(k) loans: By taking money out, you’ll dramatically slow the progress of your portfolio as well as the development of your retirement savings. That’s not necessarily true. In the first place, as mentioned above, you will repay the funds, and you start doing so in a short time. In the context of the long-term duration of the majority of 401(k)s that’s a rather tiny (and financial insignificant) interval.4

19%

The percentage that 401(k) participants with outstanding plan loans during 2016, (latest information) as per 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’s geared toward growth that’s weighed towards equity will experience fluctuations and ups, particularly in the short term.

When your 401(k) is comprised of stocks, the real impact from the short-term loans in your retirement plan will be contingent on the current market conditions. The impact is likely to be mildly negative in markets that are booming but it could be neutral or positive in down or down markets.

The good and bad information: the most appropriate time to apply for a loan would be when you feel the stock market is vulnerable or weakening, such as during recessions. Coincidentally, many people find they require money or to stay liquid during such periods.

Debunking Myths With Facts

There are two other common arguments against 401(k) loans: The loans aren’t tax-efficient, and cause a lot of difficulties when people are unable to repay them before they retire or leave work. Let’s confront these myths with facts:

Tax Inefficiency

The argument the claim is 401(k) loans are tax-inefficient since they have to be paid back using after-tax dollars, which exposes loan repayment to taxation double. Only the part of the repayment that is financed by interest is subject to such treatment. The media usually ignore the fact that the cost of double taxation on loan interest is often fairly low, when compared to cost of other methods to access short-term liquidity.

Here’s an example that is too often very real: Imagine that Jane is able to make steady savings progress by deferring 7percent of her earnings to her 401(k). However, she will soon have to draw $10,000 to pay for tuition expense for college. She expects to pay back this amount by taking her salary for about a year. She is in the 20% tax bracket for both the state and federal. Here are three methods she can access the cash:

Take a loan from your 401(k) for a “interest amount” of 4percent. The tax cost for double-taxation of the interest amount is the amount of $80 ($10,000 loan x 4% interest + 20% the tax rate).

You can borrow money from the bank at a rate of real interest of 8.8%. The interest rate will be $800.

Stop making 401(k) account deferrals over the course of a year, and use this funds to pay her tuition at college. In this situation she’ll forfeit her savings from retirement, have to pay more income tax in the current year and could lose any employer-matching contributions. The cost could easily be $1,000 or more.

Double taxation of 401(k) loan interest becomes an actual cost only when huge amounts are borrowed and then repayed over multiple years. Even so, it generally is less expensive than other methods of accessing similar amounts of cash via bank or consumer loans or a hiatus in plan deferrals.

Resigning from Work with an unpaid loan

If you decide to take out a plan loan and then go through a job loss. You will have to repay the loan in the full amount. If you don’t, the full remaining loan amount will be considered a tax-deductible distribution and you may also be subject to an additional 10% federal tax penalty for the balance that is not paid if you are under age 59 1/2 .6 Although this is an accurate description of the tax laws, it may not necessarily reflect the reality.

When they retire or leave working, many people opt to receive a portion or all of the 401(k) money as a taxable distribution, particularly when they are cash-strapped. Having an unpaid loan balance comes with the same tax consequences as taking this decision. Most plans do not require plan distributions upon retirement or disengagement from service.

Individuals who wish to avoid negative tax consequences should consider tapping other sources to repay your 401(k) loans before taking an income distribution. If they do, the full plan balance could be tax-advantaged rollover or transfer. If an unpaid 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 most serious issue is to take 401(k) loans while working but not having the intention or the ability to pay them back in a timely manner. In this scenario the unpaid loan balance is treated similarly to a hardship withdrawal, with tax consequences that can be negative, and perhaps also an unfavorable effect on your rights to participate in the plan.

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

Regulations require 401(k) plan loans to be paid back using an interest-based basis (that is with a set repayment schedule with regular installments) over not more than five years, unless the loan is used for the purchase of the primary residence. Payback times that are longer are permitted for these loans. The IRS doesn’t specify how long, though, so it’s something you’ll have to negotiate with the plan administrator. Ask if you’re eligible for an additional year as a result of the Cares bill.2

Also, keep in mind that CARES increased the amount that the participants are able to take out of their plans up to $100,000. The previous limit that participants may borrow from their plan was 50% of the balance of their vested account or $50, depending on what is lower. If your vested account balance is less than $10,000, then you are still able to borrow up to $10,000.2

A loan from a 401(k) to fully finance a residential purchase might not be as appealing as an mortgage loan. Plan loans do not offer tax-free interest payments unlike the majority of mortgages. While the ability to withdraw and pay back within five years is fine under the normal rules that is 401(k) things, the impact on your retirement goals for the loan which must be paid back over a number of years could be significant.

However it is possible that a 401(k) loan might work for you if you require immediate funds to cover the closing costs associated with buying a home. It will not affect your eligibility for a mortgage, either. Since that the 401(k) loan isn’t technically an obligation–you’re taking out your own money, after all–it has no impact on your ratio of debt to income or on your score on credit, which are two of the major factors that influence the lenders.

If you do need an amount of money to buy the house you’ve always wanted and wish to utilize 401(k) funds then you could think about a hardship withdrawal instead of, or as an alternative to the loan. You will be required to pay an income tax for the cash withdrawal as well as when the amount is greater than $10,000, you will be subject to a 10% penalty is due as well.7

The Bottom Line

The argument about 401(k) loans “rob” or “raid” retirement accounts usually contain two flaws They assume constant high returns on stocks within the 401(k) portfolio but fail to consider the cost of interest when borrowing similar amounts through a bank or other consumer loans (such as the accumulation of the balance of credit cards).

Don’t be afraid of an excellent liquidity option that is included within the 401(k) plan. When you lend yourself appropriate amounts of money for the appropriate short-term goals they can be the simplest, most convenient, and lowest-cost option for cash. Before you make any loan it is important to have a plan in your mind for repaying these amounts on schedule or earlier.

Mike Loo, vice president of wealth management at Trilogy Financial, puts it as follows “While one’s circumstances in taking an 401(k) loan may vary however, one way to prevent the risks of taking one at all is preemptive. If you are able to plan ahead, set financial goals for yourself, and commit to saving some of your money both often and early You may discover that you have the funds you need in a different account than your 401(k), thereby preventing the need to take the 401(k) loan.”