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

401(k) Loan Basics

The 4 most compelling reasons to borrow

Stock Market Myths

Debunking Myths With Facts

401(k) loans to purchase the Home of your choice

The Bottom Line

Retirement Plan 401(k)

Four Reasons to Borrow Money from Your 401(k)

When is the best time to get a 401(k) loan? When the stock market is falling

By Troy Segal

Updated January 25, 2022

Review by David Kindness

The factual information is verified by Skylar Clarine

Skylar Clarine

The financial media have coined some snarky terms to explain the dangers that come with borrowing from a 401(k) plan. Some, including financial planners, would claim that taking a loan from a 401(k) scheme is a robbery committed to derail your retirement.

However, the 401(k) loan can be appropriate in some situations. Let’s look at the ways in which the loan could be used sensibly and why it need not be a problem for your retirement savings.

The most important takeaways

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

The reasons to borrow money from your 401(k) include convenience and speed and flexibility in repayment, cost advantage, and potential advantages for your savings in a down market.

The most common arguments against taking out the loan include a negative impact on performance in the investment market, tax efficiency as well as the possibility of leaving the job due to unpaid loan will have undesirable effects.

A weak stock market may be one of the best times to take an 401(k) loan.

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

If you need to find funds for a critical urgent liquidity requirement then a loan from your 401(k) plan is likely to be the first place you should look. Short-term is defined as at least a year. It is possible to define «serious liquidity requirement» as a significant one-time demand for funds or a lump-sum cash payment.

Kathryn B. Hauer, MBA, CFP(r), a financial planner for Wilson David Investment Advisors and the author of Financial Tips on Blue Collar America put it this way: «Let’s face it, in the real world, there are times when people need money. In fact, borrowing through your 401(k) is financially smarter then taking out a costly high-interest title loan or pawn or payday loan, or even a affordable personal loan. It will cost you less in the long run. «1

Why is your 401(k) an excellent source for short-term loans? It’s because it’s the fastest, most simple, lowest-cost way to get the cash you need. The receipt of a loan through your 401(k) is not an event that is tax-deductible unless the loan restrictions and repayment guidelines are violated. It also does not affect your credit rating.

If you repay an unrepayable loan according to the timeframe typically, it has no effect on the progress of your retirement savings. In fact, in certain circumstances, it may have a positive impact. Let’s dig a little more deeply to find out why.

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Image of Sabrina Jiang (c) Investopedia 2020

401(k) Loan Basics

Technically, 401(k) loans are not real loans since they do not involve either an appraisal by a bank or a review of your credit history. They can be better defined as being able to access a portion of your retirement plan’s money—usually as much as 50% or $50,000 of your assets, whichever is less, on an tax-free basis.2 Then, you must repay the money you access to under rules that are designed to return the condition of your 401(k) account to approximately the same condition like if the transaction has been unintentional.

Another confusing concept in the transactions is interest. Any interest charged on the remaining loan balance is paid back by the participant into the participant’s personal 401(k) account, which means that technically, it’s an exchange from one pocket to another, not the case with a loss or borrowing expense. This means that the cost of a 401(k) loan on your savings in retirement can be minimal, neutral, in some cases even positive. However, in the majority of cases, it’ll be less than the cost of paying real interest on a consumer or bank loan.

How to Be an 401(k) Millionaire

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

The top four reasons to turn at your 401(k) to meet your urgent immediate cash needs include:

1. Speed and Convenience

In the majority of 401(k) programs, getting a loan is easy and fast, requiring no lengthy requests as well as credit screening. Normally, it does not cause an inquiry to your credit rating or impact your credit score.

Many 401(k)s allow loan request to be submitted with just the click of a website, and you can have funds in your account in just only a few days, and with complete privacy. One of the latest innovations being embraced by certain schemes is using a debit cards, with which multiple loans can be made instantly in small amounts.3

2. Repayment Flexibility

Although the regulations stipulate a five-year amortizing repayment schedule, 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 repayment to be paid by payroll deductions, using tax-free dollars, but not pretax funds that are credited to your plan. Your statements from your plan will show the amount of credit to your loan account and your resting principal balance just like a regular bank loan statement.

3. Cost Advantage

There’s no cost (other other than maybe a small loan administrative or origination cost) to access your personal 401(k) money for short-term liquidity needs. Here’s how it usually works:

You select the account or account(s) from where you wish to obtain money. the investments are liquidated for the duration of the loan. Therefore, you lose any gains that would be earned from those investments for a limited time. In the event that the market is down and you sell the investments at a lower price than other times. The upside is that you also avoid any future losses to your investment cash.

The cost benefit of the 401(k) loan is the equivalent of the rate of a comparable consumer loan plus any investment earnings from the principal loan you took. Here’s a quick formula:

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

Let’s suppose you apply for a personal loan or cash advance with a credit card at an interest rate of 8. The 401(k) account is earning 5 percent return. Your benefit from borrowing from the 401(k) plan is 3% (8 — 5 is 3).

If you are able to estimate that the cost advantage is positive and the plan loan can be attractive. Be aware that this calculation doesn’t take into consideration the tax implications, which can increase the benefits of a plan loan since consumers loan interest is repaid with tax-free dollars.

4. Retirement Savings Can Benefit

If you make loan payments to the 401(k) account generally, they will be remitted to your investment portfolio. You will repay the account a bit more than the amount you borrowed, and the difference is called «interest.» The loan produces no (that is it is neutral) impact on your retirement plan if loss in investment earnings are equal to the «interest» that you pay in—i.e., earnings opportunities are offset dollar-for-dollar by interest payments.

If the amount of interest you pay is greater than any lost investment earnings taking out a 401(k) loan can actually increase your retirement savings progress. Keep in mind that this can decrease your personal (non-retirement) saving.

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 development of your retirement nest egg. It’s not always the case. In the first place, as stated above, you must have to repay the funds and you begin to do so very quickly. Given the long-term horizon of the majority 401(k)s this is a fairly small (and financial insignificant) interval.4

19%

The proportion that 401(k) participants with unpaid plan loans during the year 2016 (latest information) as per an investigation 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 is geared towards growth and oriented towards equity will experience fluctuations and ups, particularly in the short-term.

If you have a 401(k) is comprised of stocks, the true impact on short-term loans on your retirement plan will be contingent upon the market conditions. The impact is likely to be mildly negative in up markets that are strong however it could be neutral, or even positive in sideways or down markets.

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

Debuting Myths With Facts

There are two other common arguments against 401(k) loans: The loans aren’t tax efficient and cause a lot of headaches when participants can’t repay them before leaving work or retiring. Let’s dispel these myths by presenting facts:

Tax Inefficiency

The claim is that 401(k) loans are tax-inefficient because they must be repaid using after-tax dollars, which exposes loan repayment to taxation double. Only the interest portion of the repayment is subject to such treatment. Media often fail to note that the cost of double taxation of loan interest is often fairly small, compared with the costs of other ways to access liquidity in the short term.

Here’s a scenario that is too often very real: Let’s say Jane makes steady retirement savings progress by deferring 7percent of her earnings into her 401(k). However, she’ll have to draw $10,000 to pay for cost of tuition for her college. She expects to pay this loan back by taking her salary for about one year. She is in a 20% federal and state tax bracket. There are three ways she can tap the cash:

You can borrow money out of your 401(k) with an «interest percentage» of 4.4%. The cost of taxing double on the interest amount is the amount of $80 ($10,000 loan x 4% interest + 20 percent taxes).

Borrow from the bank with a real rate of 8percent. The cost of interest will be $800.

Don’t make 401(k) account deferrals for one year and use this funds to pay her tuition to college. In this scenario she’ll lose her real savings from retirement, have to pay higher income tax rates as well as lose any employer-matching contributions. The cost could easily be at least $1,000.

The double-taxation associated with 401(k) loan interest becomes a meaningful cost only when huge amounts are borrowed and then repayed over multiple years. Even so, it generally is less expensive than other options for accessing similar amounts of cash via bank or consumer loans or a suspension in deferrals from the plan.

Leaving Work With an Unpaid loan

Suppose you take a plan loan and then lose your job. You’ll have to pay back the loan in total. If you don’t then the total not paid loan amount is classified as a tax-deductible distribution and you could also face 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 the most accurate way to describe the tax laws, it doesn’t always reflect reality.

In the event of retirement or a separation from working, many people opt to receive a portion from their 401(k) money as a taxable distribution, especially if they are cash-strapped. Having an unpaid loan balance comes with similar tax consequences to the decision. Many plans do not require distributions upon retirement or disengagement from service.

Individuals who wish to avoid negative tax consequences can tap other sources to pay off the 401(k) loans before taking an income distribution. If they do then the total balance could be tax-free rollover or transfer. If an not paid loan balance is included in the participant’s taxable income and the loan is then repaid the 10% penalty does not apply.7

The more serious problem is when you take 401(k) loans while working but not having the intention or ability to repay them according to a schedule. In this situation, the not paid loan balance is treated in a similar way to a hardship withdrawal with negative tax consequences and, possibly, an unfavorable impact on plan participation rights.

401(k) loans to purchase the Home of your choice

Regulations require 401(k) program loans to be paid back in an amortizing manner (that is with a fixed repayment plan in regular installments) in no more than five years, unless the loan is used to purchase an primary residence. Longer payback periods are allowed for these specific loans. The IRS does not provide a timeframe for the loan the payback period will be, however, it’s something to work out with the plan’s administrator. And ask whether you get an additional year as a result of the Cares bill.2

Also, keep in mind that CARES has increased the amount plan members can take out of their plans up to $100,000. The previous limit that participants may take out from their plans was 50 percent of the vested account balance (or $50,000), whichever is less. If the balance of your vested accounts is less than $10,000, you are still able to borrow up to $10,000.2

Borrowing from a 401(k) to fully finance an investment in a house isn’t as attractive than a mortgage loan. Plan loans don’t provide tax deductions for interest payment like the majority of mortgages. And, while taking out and paying back your loan within 5 years is acceptable within the typical framework for 401(k) things, the impact on your retirement plan for a loan that must be paid back over many years can be significant.

However, a 401(k) loan might work in the event that you require urgent cash to pay for the down payment or closing costs associated with buying a home. It will not affect your eligibility for a mortgage, neither. Because the 401(k) loan isn’t technically an obligation—you’re taking out your own money at the end of the day, so it doesn’t have any effect on your debt-to-income ratio or your credit score, two big elements that affect lenders.

If you do need a sizable sum to purchase an apartment and you want to utilize 401(k) funds, you might think about a hardship withdrawal instead of or in addition to the loan. But you will owe an income tax for the cash withdrawal and when the amount is more than $10,000, a 10% penalty as well.7

The Bottom Line

Arguments that 401(k) loans «rob» or «raid» retirement accounts typically include two flaws They assume constant strong stock market returns in the 401(k) portfolio, and they fail to consider the costs of borrowing similar amounts via banks or other types of consumer loans (such as accruing the balance of credit cards).

Don’t be afraid to explore a valuable liquidity option embedded within your 401(k) scheme. If you are able to borrow the right amounts of cash for appropriate short-term goals they can be the simplest, most convenient, and lowest-cost option for cash. Before you take any loan it is important to 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 a 401(k) loan may vary however, one way to prevent the risks of getting one in the first place is to be proactive. If you’re able to take the time to preplan, set financial goals for yourself, and commit to saving some money often and early, you may find that you have the money in a different account from your 401(k) which will eliminate the necessity of taking a 401(k) loan.»