The financial media have coined a few pejorative phrases to describe the pitfalls of borrowing money from a 401(k) plan. Some of them – and some financial planning professionals, too – would even have you believe that taking a loan from a 401(k) plan is an act of robbery committed against your own retirement.
Not everyone believes it, though. 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.
Below, we'll take a look at how such a loan could be used sensibly and why it need not spell trouble for your retirement savings.
When a 401(k) Loan Works
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 something beyond a sudden yearning for a 42-inch flat-screen TV – a one-time demand for funds or a lump-sum cash payment.
Kathryn B. Hauer, MBA, CFP®, a financial planner with Wilson David Investment Advisors in Aiken, S.C., and author of "Financial Advice for Blue Collar America," puts 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.
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 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.
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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:
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 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.
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 your plan is funded with). Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement.
3. Cost Advantage: 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 principal you borrowed. Here is a simple formula:
Cost of consumer loan interest – investment earnings (lost) over the loan period = cost advantage
Let's say you could take out a bank personal loan or take a cash advance from a credit card. at 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. (Note: 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. Your Retirement 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 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. In fact, if the interest paid in exceeds any lost investment earnings, taking a 401(k) loan actually can increase your retirement-savings progress.
Stock Market Myths
The above discussion leads us to address another (erroneous) argument regarding 401(k) loans: that 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.
The other problem with the bad-impact-on-investments reasoning: It tends to assume the same rate of return over the years. And the stock market doesn't work like that. A growth-oriented portfolio that's weighted towards equities will have its 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.
If possible, 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 have a need for funds or to stay liquid during such periods.
Addressing Two Myths
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:
1.) 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. Actually, 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 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.
2.) Leaving Work With an Unpaid Loan: Suppose you take a plan loan and then get fired. You will have to repay the loan in full; 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 59½. While this scenario is an accurate description of tax law, it doesn't always reflect reality:
- At retirement or separation from employment, many people often choose to take part of their 401(k) 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 Home
Regulations require 401(k) plan loans to be repaid on an amortizing basis (that is, with a fixed repayment schedule in regular installments) 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 (the IRS doesn't specify how long, though; it's something to work out with your individual plan administrator).
The maximum amount a participant may borrow from his or her plan is 50% of his or her vested account balance or $50,000, whichever is less. If the vested account balance is less than $10,000, you can still borrow up to $10,000.
Borrowing from a 401(k) to completely finance a residential purchase may not be as attractive as a taking out a mortgage loan. Plan loans do not offer tax deductions for interest payments, as do most types of mortgages. And, while withdrawing and repaying within five years is fine in the usual scheme of 401(k) things, the impact on your retirement progress for a loan that has to be paid back over many years can be significant.
However, a 401(k) loan might work well if you need immediate funds to cover the down payment for a home or the closing costs. It won't affect your qualifying for a mortgage, either: Since the 401(k) loan isn't technically a debt – you're withdrawing your own money, after all – it has no effect on your debt-to-income ratio or on your credit score, two big factors that influence lenders.
If you do need a sizeable sum to purchase a house, and want to use 401(k) funds, you might consider a hardship withdrawal instead of, or in addition to, the loan instead. But you will owe income tax on the withdrawal and if the amount's above $10,000, a 10% penalty as well.
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 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 in Irvine, California, 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 plan ahead, 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."