The financial media has coined a few pejorative phrases to describe the pitfalls of borrowing money from a 401(k). Some members of the financial press would even have you believe that taking a loan from a 401(k) plan is an act of robbery committed against your own retirement. However, this idea may be more urban myth than reality. 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. Clearly, these loans have a following and, in fact, they can be appropriate in some situations. Let's take a look at how such a loan could be used sensibly and why it need not spell trouble for your retirement savings (For related reading, see Eight Reasons To Never Borrow From Your 401(k).)
When a 401(k) Loan Works
When you must find cash for a serious short-term liquidity need, a loan from your 401(k) plan probably is one of the first places you should look. Let's define "short-term" as being roughly a year or less. Let's define "serious liquidity need" as not including a sudden yearning for a 42-inch flat-screen TV.
Why is your 401(k) an attractive source for such loans? It can be the quickest, simplest, lowest-cost way to get the cash you need. Receiving a loan is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on your credit rating. Assuming you pay back a short-term loan on schedule, it usually will have little impact on your retirement savings progress. In fact, in some cases, it can even have a positive impact. Let's dig a little deeper to explain why. (If you are unfamiliar with how 401(k) loans work, a useful overview can be found in the article Borrowing From Your Plan.)
401(k) Loan Basics
Technically, 401(k) loans are not true loans, because they do not involve either a lender or an evaluation of your credit. They are more accurately described as the ability to access a portion (usually the lesser of 50% or $50,000) of your own retirement plan money on a tax-free basis. You then must repay the money you have accessed under rules designed to restore your 401(k) plan to approximately its original state, as if the transaction had not occurred.
Another confusing concept in these transactions is the term "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 also is a transfer from one pocket to another, not a borrowing cost or loss. As such, the cost of a 401(k) loan on your retirement savings progress can be minimal, neutral, or even positive, but in most cases it will be less than the cost of paying "real interest" on a bank or consumer loan.
Four Reasons to Borrow From Your 401(k)
The top four reasons to look to your 401(k) for serious short-term cash needs are:
- Speed and Convenience - In most 401(k) plans, requesting a loan is quick and easy, requiring no lengthy applications or credit checks. Normally, it does not generate an inquiry against your credit or affect your credit rating. Many 401(k)s allow loan requests to be made with a few clicks on a website, and you can have a check in your hand in a few days, with total privacy. One innovation now being adopted by some plans is a debit card through which multiple loans can be made instantly in small amounts.
- Repayment Flexibility – Although regulations specify a five-year amortizing repayment schedule, for most 401(k) loans, you can repay the plan loan faster with no prepayment penalty. Most plans allow loan repayment to be made conveniently through payroll deductions (using after-tax dollars). Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement.
- Economy - There is no cost (other than perhaps a modest loan origination or administration fee) to tap your own 401(k) money for short-term liquidity needs. Here's how it usually works: You specify the investment account(s) from which you want to borrow money. Those investments are liquidated for the duration of the loan. Therefore, you lose any positive earnings that would have been produced by those investments for a short period of time. The upside is that you also avoid any investment losses on this money.
The cost advantage of a 401(k) loan is the equivalent of the interest rate charged on a comparable consumer loan minus any lost investment earnings on the plan loan principal. Here is a simple example:
Cost of interest charged on a comparable consumer loan (8%) - Investment earnings (lost) over the loan period (7%) = Cost advantage (1%)
Whenever you can estimate that the cost advantage will be positive, a plan loan can be attractive. (This calculation ignores tax impact, which can increase the plan loan's advantage because consumer loan interest is repaid with after-tax dollars.)
- Your Retirement Can Benefit - As you make loan repayments to your 401(k) account, they usually are allocated back into the investments you have chosen. You will repay to the account a bit more than you borrowed from it, and the difference is called interest. The loan produces no (that is to say, neutral) impact on your retirement if any lost investment earnings match the "interest" paid in – i.e., earnings opportunities are offset dollar-for-dollar by interest payments. If the interest paid in exceeds any lost investment earnings, taking a 401(k) loan actually can increase your retirement progress.
In short, if your 401(k) balance is invested in stocks, the real impact of short-term loans on your retirement progress will depend on the market environment. The impact should be modestly negative in strong up markets and it can be neutral, or even positive, in sideways or down markets.
If you understand this point, you will see that the best time to take a loan is when you feel the stock market might be vulnerable or weakening (such as during recessions). Coincidentally, many people find that they need short-term liquidity during such periods.
Addressing Two Flaws
The illustrations used by the financial media to show how 401(k) loans "rob" or "raid" retirement accounts often include two flaws:
- They assume strong stock market returns in the 401(k).
- They fail to consider the interest cost of borrowing similar amounts via bank or consumer loans (such as racking up credit card balances).
Potential stock market returns are always speculative, while the cost of bank and consumer loan interest is known and real. If you are ignoring the potential to take a short-term loan from your 401(k) while watching your credit card balances zoom upward, it might be time to stop putting so much faith in these illustrations.
Addressing Two Myths
The financial media also propagates two myths that argue against 401(k) loans: The loans are not tax-efficient; and they create enormous headaches when participants can't pay them off before leaving work or retiring. Let's confront these myths with facts:
- Tax Inefficiency - The media claim 401(k) loans are tax inefficient because they must be repaid with after-tax dollars, subjecting loan repayment to double taxation. Actually, only the interest portion of the repayment is subject to such treatment. (You can read a balanced account of why this occurs in the article Should You Take A Loan From Your Plan?)
The media usually fail to note that the cost of double-taxation on loan interest is often fairly small compared to the cost of alternative ways to tap short-term liquidity.
Here is a hypothetical situation that is too often very real: Suppose that Jane is making steady retirement savings progress by deferring 7% of her salary into her 401(k). However, she will soon need to tap $10,000 to meet a college tuition bill. She anticipates that she can repay this money from her salary in about a year. She is in a 20% combined federal and state tax bracket. Here are three ways she can tap the cash:
- Borrow from her 401(k) at an "interest rate" of 4%. Her cost of double-taxation on the interest is $80 ($10,000 loan x 4% interest x 20% tax rate).
- Borrow from the bank at a real interest rate of 8%. Her interest cost will be $800.
- Stop making 401(k) plan deferrals for a year and use this money to pay her college tuition. In this case, she will lose real retirement savings progress, pay higher current income tax, and potentially lose any employer-matching contributions. The cost could easily be $1,000 or more.
Double taxation of 401(k) loan interest becomes a meaningful cost only when large amounts are borrowed and then repaid over multiyear periods. Even then, it usually has a lower cost than alternative means of accessing similar amounts of cash through bank/consumer loans or a hiatus in plan deferrals.
- Leaving Work With an Unpaid Loan - This myth is sometimes cast as follows: Suppose you take a plan loan and then get fired. You will have to repay the loan in full before you take a plan distribution. Otherwise, the full unpaid loan balance will be considered a taxable distribution, and you could also face a 10% federal tax penalty on the unpaid balance if you are under age 59.5.
This scenario is an accurate description of tax law, but it doesn't always reflect reality:
- At retirement or separation from employment, many people choose to take part of their money as a taxable distribution, especially if they are cash-strapped. Having an unpaid loan balance has similar tax consequences to making this choice.
- Most plans do not require plan distributions at retirement or separation from service, and individuals often are given a grace period of 60 or 90 days to arrange plan-loan repayment after leaving work.
- People who want to avoid negative tax consequences can tap other sources to repay their 401(k) loans prior to taking a distribution. If they do so, the full plan balance can qualify for a tax-advantaged transfer, or rollover. If an unpaid loan balance is included in the participant's taxable income and the loan is subsequently repaid, the 10% penalty does not apply.
The more serious problem is to take 401(k) loans while working without having the intent or ability to repay them on schedule. In this case, the unpaid loan balance is treated similarly to a hardship withdrawal, with negative tax consequences and perhaps also an unfavorable impact on plan participation rights.
401(k) Loans to Purchase a Primary Residence
Regulations require 401(k) plan loans to be repaid on an amortizing basis over not more than five years, unless the loan is used to purchase a primary residence. Longer payback periods are allowed for these particular loans.
Evaluating the use of 401(k) plan loans for home purchases is complex, and plan loans may not be as attractive as mortgage loans. Plan loans do not offer tax deductions for interest payments, as do most types of mortgages, home-equity loans and home-equity lines of credit. The impact on your retirement progress for a loan paid back over many years can be significant. It is best to consult personal tax and financial advisors before taking such loans.
The Right Liquidity Source for the Right Reason
Don't let the financial media scare you away from a valuable liquidity option embedded in your 401(k) plan. When you loan yourself appropriate amounts of money for the right short-term reasons, these transactions can be the simplest, most convenient and lowest-cost source of cash available. Before taking any loan, you should always have a clear plan in mind for repaying these amounts on schedule or earlier.