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

401(k) Loan The basics

Top 4 Reasons to Borrow

Stock Market Myths

Debunking 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 a 401(k) loan? When the market is down

By Troy Segal

Updated January 25, 2022

Review by David Kindness

Fact checked by Skylar Clarine

Skylar Clarine

The financial press has come up with a few pejorative terms to explain the dangers of borrowing money from the 401(k) program. Some experts, including financial planners, may claim that taking out a loan from the 401(k) plan is a fraud committed to derail your retirement.

But the 401(k) loan can be appropriate in some situations. Let’s examine how such loan loan could be utilized wisely and also why it shouldn’t be a problem to your savings for retirement.

The most important takeaways

When done for the proper reasons, taking an immediate 401(k) loan and paying the loan back on time can be a good option.

The reasons to borrow from your 401(k) include speed and convenience, repayment flexibility, cost advantage, and possible advantages to your retirement savings during a down market.

Common arguments against taking the loan are negative effects on the performance of investments, tax inefficiency as well as the possibility of leaving a job with unpaid loan will have undesirable consequences.

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

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

If you’re looking for funds for a critical urgent liquidity requirement then a loan from your 401(k) plan is likely to be the first place you’ll need to consider. We’ll define «short-term» as approximately a year or less. Let’s define «serious liquidity need» as a serious 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 author of Financial Tips on Blue Collar America said it this way: «Let’s face it, in the real world, at times people require money. In fact, borrowing through your 401(k) can be more financially prudent as opposed to taking out a cripplingly high-interest title loan or pawn or payday loan, or even a reasonable personal loan. It’s cheaper in the long run. «1

Why is your 401(k) an appealing source for short-term loans? Because it is the most efficient, simple, and lowest-cost way to get the money you need. Receiving a loan through your 401(k) isn’t an event that is tax-deductible unless the loan restrictions and repayment guidelines are violated, and it does not affect your credit score.

If you are able to repay a short-term loan in a timely manner generally, it will have little effect on your retirement savings progress. In fact, in some cases, it can even be beneficial. Let’s go a little deeper to explain the reasons.

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Image by Sabrina Jiang (c) Investopedia 2020

401(k) Loan Basics

Technically speaking, 401(k) loans are not real loans since they don’t involve a lender or an evaluation of your credit history. They can be described as having the capability to access a portion of your retirement plan’s money—usually as much as 50% or $50,000 of your total assets or less, on an untaxed basis.2 Then, you must repay the money you have obtained under the rules that are designed to restore your 401(k) program to the same condition in the same way as if the transaction had not taken place.

Another tricky concept to grasp in these transactions is the term interest. Any interest charged on the unpaid loan balance is paid back by the participant to the participant’s 401(k) account, so technically, it is a transfer from your pocket to another, and not a borrowing expense or loss. Therefore, the impact of a 401(k) loan on your retirement savings progress can be low, neutral, and even positive. But in most cases, it will be lower than paying the real cost of interest on a personal or commercial loan.

How to Be a 401(k) Millionaire

The Top 4 Benefits of Borrowing 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) plan, getting an loan is quick and easy, requiring no lengthy requests as well as credit screening. Normally, it does not cause an inquiry to your credit or affect your credit score.

Many 401(k)s allow loan applications to be made with only a couple of clicks on an online site, and you can have funds in your hand in only a few days, and with complete security. One new feature that is being used by some plans is a debit card with which multiple loans can be made immediately in tiny amounts.3

2. Repayment Flexibility

While regulations require the amortization schedule for five years, for most 401(k) loans, you can repay the plan loan sooner and with no penalty for prepayment penalty.2 The majority of plans permit loan repayement to be paid easily through payroll deductions using tax-free dollars, but not pretax dollars that fund your plan. The statements of your plan show credit towards your loan account and the outstanding principal balance much as a normal bank loan statement.

3. Cost Advantage

There is no cost (other other than maybe a small loan origination or administration fee) to access your personal 401(k) money to meet short-term liquidity needs. This is how it operates:

You choose an investment account(s) from which you want to borrow money. those investments are liquidated for the time period that you loan. This means that you will lose any earnings that could have been earned by these investments for a short period. If the market is in decline, you are selling the investments at a lower price than at other times. The upside is that you also avoid any future losses to your investment capital.

The cost benefit of the 401(k) loan is the equivalent of the rate on the same consumer loan minus any lost 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-Lost Investment Earnings

Let’s say you could get a personal bank loan or cash advance with credit card with an interest rate of 8. The 401(k) account is generating an annual return of 5. The cost benefit of taking out loans from your 401(k) plan is 3percent (8 5 x 8 equals 3).

If you are able to estimate that the cost benefit is positive and an option for a plan loan can be attractive. Remember that this calculation doesn’t take into consideration the tax implications that could increase the plan loan’s advantage because consumers loan interest is repaid with tax-free funds.

4. Retirement Savings Can Benefit

As you make loan repayments into the 401(k) account, they usually are allocated back to the portfolio’s investments. You’ll have to repay the account a bit more than the amount you borrowed, and the difference is called «interest.» The loan does not have any (that is to say, neutral) effect on retirement plan if lost investment earnings match the «interest» paid in—i.e. earning opportunities are offset dollar-for-dollar by interest payments.

If the amount you pay for interest is higher than the investment losses taking out a 401(k) loan can actually boost your savings for retirement. Remember however that this can lower the amount of your individual (non-retirement) funds.

Stock Market Myths

The above discussion leads us to consider a second (erroneous) argument regarding 401(k) loans: By taking money out, you’ll dramatically hinder the performance of your portfolio as well as the building up of your retirement nest egg. That’s not necessarily true. As noted above, you do pay back the money, and you begin doing it very quickly. In the context of the long-term duration of most 401(k)s, it’s a pretty small (and financially irrelevant) interval.4

19%

The percentage of 401(k) participants who had outstanding plan loans during 2016, (latest information), according to a study conducted 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 growth-oriented portfolio that’s weighted toward equities will have fluctuations and ups, particularly in the short term.

If your 401(k) is comprised of stocks, the true impact on the short-term loans on your retirement progress will be contingent on the market conditions. The effect should be moderately negative in markets that are booming however it could be neutral, or even positive in sideways or down markets.

The grim but good news: the best time to get the loan will be when feel the market is in danger or weakening, for instance during recessions. In the course of time, many find that they need funds or to stay liquid during these times.

Debuting Myths With Facts

There are two other popular arguments that are made against 401(k) loans: The loans aren’t tax-efficient, and they create enormous problems when the participants aren’t able to pay them off 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 due to the fact that they must be repaid using tax-free dollars after tax, thereby exposing loan repayment to double taxation. Only the part of the repayment that is financed by interest is subject to such treatment. Media often fail to note that the price of double taxation of loan interest is usually tiny, when compared to the cost of alternative ways 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 7% of her salary into your 401(k). However, she’ll require a withdrawal of $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 the 20% tax bracket for both the state and federal. Here are three methods she can access the cash:

Take a loan out of the funds in her 401(k) for a «interest amount» of 4%. Her cost of double-taxation on the interest amount is $80 ($10,000 loan x 4% interest + 20% the tax rate).

You can borrow money from the bank at a real interest rate of 8%. Her interest cost is $800.

Do not make 401(k) plan deferrals over the course of a year, and use the cash to pay for her tuition to college. In this situation she’ll forfeit her retirement savings , be subject to higher current income tax and could be unable to receive any employer-matching contributions. It could cost up to $1,000.

Taxation on double taxation for 401(k) loan interest becomes an actual cost only when huge amounts are borrowed and then paid back over a long period of time. Even so, it generally is less expensive than other options for accessing the same amount of cash via bank or consumer loans or a pause in deferrals from the plan.

Leaving Work With an Unpaid Credit

Suppose you take a plan loan and then go through a job loss. Then you must repay the loan in the full amount. If you fail to do so pay the entire remaining loan balance will be considered a taxable distribution, and you could be subject to an additional 10% federal tax penalty on the unpaid balance when you’re under the age of 59 1/2 .6 While this scenario is an accurate description of taxes, the law does not necessarily reflect the reality.

In the event of retirement or a separation from employment, many people often decide to use a portion from their 401(k) funds as a taxable distribution, particularly if they’re cash-strapped. A unpaid loan balance comes with similar tax implications to making this choice. Many plans do not require plan distributions upon retirement or the retirement from service.

If you want to stay clear of negative tax consequences should consider tapping other sources to pay off your 401(k) loans before taking an income distribution. If they do, the full plan balance is eligible for tax-free rollover or transfer. If the outstanding loan balance is included in the participant’s tax-deductible income, and the loan is later repaid, the penalty of 10% does not apply.7

The bigger issue is to take 401(k) loans while working with no intention or the ability to pay them back in a timely manner. In this situation the not paid loan amount is treated similar to a hardship withdrawal, with tax consequences that can be negative, and possibly an adverse effect on your rights to participate in the plan.

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

Regulations make it mandatory for 401(k) plan loans to be repaid on an amortizing basis (that is that, with a fixed repayment schedule in regular installments) over not more than five years unless they are loan is used to buy the primary residence. Longer payback periods are allowed for these particular loans. The IRS does not provide a timeframe for the loan the payback period will be, however, it’s something to work out with your plan’s administrator. Ask if you’re eligible for an extra year because of the CARES bill.2

Also, keep in mind that CARES increased the amount that participants can borrow from their plans to $100,000. The previous limit that participants could borrow from their plan is 50% of the vested account balance or $50,000, whichever is less. If your vested account balance is lower than $10,000, you may still be able to borrow $10,000.2

Borrowing from the 401(k) to finance completely an investment in a house isn’t as attractive as taking out a mortgage loan. Plans loans don’t provide tax-free interest payments unlike the majority of mortgages. While withdrawing and repaying within 5 years is acceptable under the normal rules for 401(k) things however, the effect on your retirement progress for those with a loan which must be paid back over a number of years could be significant.

However an 401(k) loan might work well if you need immediate cash to pay for the down payment or closing costs for a home. It will not affect your eligibility for a mortgage, either. Since it’s a 401(k) loan isn’t technically a loan—you’re just withdrawing the money you own 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 the lenders.

If you need to borrow the money to buy the house you’ve always wanted and wish to use 401(k) funds, you might consider a hardship withdrawal instead of, or as an alternative to, the loan. But you will owe taxes on income earned from the withdraw as well as when the amount is more than $10,000, you will be subject to a 10% penalty as well.7

The Bottom Line

arguments about 401(k) loans «rob» or «raid» retirement accounts often have two problems They assume that they will always have strong stock market returns within the 401(k) portfolio but don’t take into account the costs of borrowing similar amounts through banks or other types of consumer loans (such as accruing debt on credit cards).

Don’t be afraid to explore an excellent liquidity option that is included in your 401(k) plan. When you borrow appropriate amounts of money for right short-term reasons These transactions could be the most simple, affordable, and most cost-effective cash source available. Before you make any loan, you should always have a plan in your mind to repay these loans on schedule or earlier.

Mike Loo, vice president of wealth management at Trilogy Financial, puts it as follows «While the circumstances of a person who needs to take an 401(k) loan may vary however, one way to prevent the negatives of taking one in the first place is preemptive. If you can take the time to preplan, set goals in your finances and make a commitment to save some of your money both often and early, you may find that you have the money in an account other than your 401(k) which will eliminate the need to take an 401(k) loan.»