The financial media have coined a few pejorative phrases to describe the pitfalls of borrowing money from a 401(k) plan. Some—including financial planning professionals—would even have you believe that taking a loan from a 401(k) plan is an act of robbery committed against 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 why it need not spell trouble for your retirement savings.

### Key Takeaways

• When done for the right reasons, taking a short-term 401(k) loan and paying it back on schedule isn’t necessarily a bad idea.
• Reasons to borrow from your 401(k) include speed and convenience, repayment flexibility, cost advantage, and potential benefits to your retirement savings in a down market.
• Common arguments against taking a loan include a negative impact on investment performance, tax inefficiency, and that leaving a job with an unpaid loan will have undesirable consequences.
• A weak stock market may be one of the best times to take a 401(k) loan.

## When a 401(k) Loan Makes Sense

When you must find the 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 a serious one-time demand for funds or a lump-sum cash payment—or, to state the obvious, a major crisis like the coronavirus outbreak that interrupts your regular income flow.

Kathryn B. Hauer, MBA, CFP®, a financial planner with Wilson David Investment Advisors and author of "Financial Advice for Blue Collar America" put it this way: "Let’s face it, in the real world, sometimes people need money. Borrowing from your 401(k) can be financially smarter than taking out a cripplingly high-interest title loan, pawn, or payday loan—or even a more reasonable personal loan. It will cost you less in the long run."

Why is your 401(k) an attractive source for short-term loans? Because 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 effect 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.

## 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 history. They are more accurately described as the ability to access a portion of your own retirement plan money—usually up to $50,000 or 50% of the assets, whichever is less—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. On March 27, 2020, President Trump signed﻿﻿ a$2 trillion coronavirus emergency relief package. It doubled the amount of 401(k) money available as a loan to $100,000. Previously it was$50,000 or 50% of your vested account, whichever is less.

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 of your pockets to another, not a borrowing expense 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.

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

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

### 1. 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 score.

Many 401(k)s allow loan requests to be made with a few clicks on a website, and you can have funds 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.

### 2. 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, though, not the pre-tax ones funding your plan. Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement.

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, and 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. And if the market is down, you are selling these investments more cheaply than at other times. The upside is that you also avoid any further 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 principal you borrowed. Here is a simple formula:

﻿\begin{aligned} \text{Cost Advantage} = \ &\text{Cost of Consumer Loan Interest} \ - \\ &\text{Lost Investment Earnings} \\ \end{aligned}﻿

Let's say you could take out a bank personal loan or take a cash advance from a credit card at an 8% interest rate. Your 401(k) portfolio is generating a 5% return. Your cost advantage for borrowing from the 401(k) plan would be 3% (8 – 5 = 3).

Whenever you can estimate that the cost advantage will be positive, a plan loan can be attractive. Keep in mind that this calculation ignores any tax impact, which can increase the plan loan's advantage because consumer loan interest is repaid with after-tax dollars.

### 4. Retirement Savings Can Benefit

As you make loan repayments to your 401(k) account, they usually are allocated back into your portfolio's investments. You will repay 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 exceeds any lost investment earnings, taking a 401(k) loan can actually increase your retirement savings progress. Keep in mind, however, that this will proportionally reduce your personal (non-retirement) savings.

## Stock Market Myths

The above discussion leads us to address another (erroneous) argument regarding 401(k) loans: by withdrawing funds, you'll drastically impede the performance of your portfolio and the building up of your retirement nest egg. That's not necessarily true. First of all, as noted above, you do repay the funds, and you start doing so fairly soon. Given the long-term horizon of most 401(k)s, it's a pretty small (and financially irrelevant) interval.﻿﻿

### 19%

The percentage of 401(k) participants with outstanding plan loans in 2016 (latest information), according to a study by the Employee Benefits Research Institute.﻿﻿

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 growth-oriented portfolio that's weighted toward equities will have ups and downs, especially in the short term.

If your 401(k) is invested in stocks, the real impact of short-term loans on your retirement progress will depend on the current 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.

The grim but good news: The best time to take a loan is when you feel the stock market is vulnerable or weakening, such as during recessions. Coincidentally, many people find that they need funds or to stay liquid during such periods.

## Debunking Myths With Facts

There are two other common arguments 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 claim is that 401(k) loans are tax-inefficient because they must be repaid with after-tax dollars, subjecting loan repayment to double taxation. Only the interest portion of the repayment is subject to such treatment. The media usually fail to note that the cost of double taxation on loan interest is often fairly small, compared with the cost of alternative ways to tap short-term liquidity.

Here is a hypothetical situation that is too often very real: Suppose Jane makes 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.

## The Bottom Line

Arguments that 401(k) loans "rob" or "raid" retirement accounts often include two flaws: They assume constantly strong stock market returns in the 401(k) portfolio, and they fail to consider the interest cost of borrowing similar amounts via a bank or other consumer loans (such as racking up credit card balances).

Don't be scared away from a valuable liquidity option embedded in your 401(k) plan. When you lend 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.

Mike Loo, an investment advisor representative for Trilogy Financial, puts it this way, "While one's circumstances in taking a 401(k) loan may vary, a way to avoid the downsides of taking one in the first place is preemptive. If you are able to take the time to preplan, set financial goals for yourself, and commit to saving some of your money both often and early, you may find that you have the funds available to you in an account other than your 401(k), thereby preventing the need to take a 401(k) loan."