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When a 401(k) Loan Makes Sense

401(k) Loan Basics

The Top 4 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 the 401(k) loan? If the market is falling

By Troy Segal

Updated 25 January 2022

Read by David Kindness

Fact checked by Skylar Clarine

Skylar Clarine

The financial media has coined a few pejorative terms to explain the dangers of borrowing money from the 401(k) scheme. Some experts, including financial planners, may have you believe that taking out a loan from a 401(k) scheme is a crime of fraud committed against your retirement.

However, it is true that a 401(k) loan can be appropriate in some situations. Let’s look at how such loan loan could be used sensibly and why it need not spell trouble to your savings for retirement.

Key Takeaways

When done for the good reasons, taking out a short-term 401(k) loan and paying it back on schedule can be a good option.

The reasons to take out a loan from the funds in your 401(k) include speed and convenience as well as repayment flexibility, cost advantage, and potential advantages to your retirement savings in a declining market.

The most common arguments against taking out a loan include a negative impact on performance in the investment market, tax efficiency and the fact that quitting the job due to an unpaid loan can have unintended results.

A weak stock market may be among the most favorable occasions to get a 401(k) loan.

If you need a 401(k) Loan Makes Sense

If you need to find funds for a critical immediate liquidity issue then a loan from the 401(k) plan could be one of the first places you’ll need to consider. Short-term is defined as roughly 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 the author of Financial Tips to Blue Collar America said it in this manner: «Let’s face it, in the real world, sometimes people require money. Borrowing from your 401(k) can be financially smarter than taking out a hefty high-interest title loan, pawn, or payday loan, or even a sensible personal loan. It’s cheaper in the long term. «1

Why is you 401(k) an excellent source of short-term loans? Because it is the most efficient, simple, and lowest-cost way to get the money you require. The receipt of a loan via 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 rating.

If you repay an unrepayable loan according to the timeframe generally, it won’t have any impact on your retirement savings progress. In fact, in certain circumstances, it may be beneficial. Let’s dig a little deeper to understand why.

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Image taken by Sabrina Jiang (c) Investopedia 2020

401(k) Loan Basics

Technically, 401(k) loans are not true loans, because they don’t involve the involvement of a lender, or an assessment of your credit background. They can be better described as the ability to gain access to a certain amount of your retirement plan’s funds–usually, up to $50,000 or 50% of your assets, whichever is lower, on an untaxed basis.2 Then, you must repay the money you have obtained under the rules that are designed to return you and your 401(k) account to its original state as if the transaction had not occurred.

Another confounding aspect of these transactions is the term interest. Any interest charged on the outstanding loan balance is paid back by the participant into the participant’s own 401(k) account, which means that technically, this also is a transfer from one of your pockets to another, not a borrowing expense or loss. This means that the cost of the 401(k) loan on your savings for retirement could be low, neutral, in some cases even positive. But in most cases, it will be less than the cost of paying real interest on a consumer or bank loan.

How to Become a 401(k) Millionaire

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

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

1. Speed and Convenience

In most 401(k) plans, getting an loan is quick and easy with no long applications as well as credit screening. Typically, it does not generate an inquiry against your credit or affect your score on credit.

Many 401(k)s permit loan applications to be made with the click of an online site, and funds could be in your hand in only a few days, and with complete confidentiality. One innovation now being adopted by certain schemes is using a debit cards through which multiple loans can be made instantly in smaller amounts.3

2. Repayment Flexibility

Although regulations specify a five-year amortizing repayment schedule for the majority of 401(k) loans, you can repay the plan loan faster with no prior payment penalty.2 The majority of plans permit loan payment to be paid conveniently through payroll deductions–using the after-tax money, however, not pretax funds that are credited to your plan. Your statements from your plan will show the amount of credit towards your loan account and your resting principal balance just as a normal bank loan statement.

3. Cost Advantage

There’s no cost (other aside from perhaps a small loan administrative or origination cost) to draw on your own 401(k) money to meet urgent liquidity needs. Here’s how it usually operates:

You select an account or account(s) from which you want to borrow money, and those investments are liquidated for the time period of the loan. So, you forfeit any gains that would have been earned by these investments for a limited time. And if the market is down, 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 money.

The benefit of the 401(k) loan is the equivalent of the rate on the same consumer loan less any loss of profits from investments from the principal loan you took. Here is a simple formula:

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

Let’s say you could take out a bank personal loan or cash advance using credit card with an interest rate of 8. Your 401(k) investment portfolio could be earning 5 percent return. Your cost advantage for borrowing from the 401(k) plan is the equivalent of 3% (8 – 5 is 3).

Whenever you can estimate that the cost advantage is positive and a plan loan could be appealing. Keep in mind that this calculation doesn’t take into consideration any tax consequences, which can increase the benefit of the plan loan because consumers loan interest is repaid using tax-free dollars.

4. Retirement Savings Can Benefit

As you make loan payments into the 401(k) account typically, they are redirected to your investment portfolio. You’ll have to repay the account a bit more than you borrowed from it, and this is referred to as «interest.» The loan produces no (that is to say that it has no) impact on your retirement, if loss in investment earnings are equal to the «interest» that you pay in–i.e. earning opportunities are offset dollar-for-dollar by interest payments.

If the amount you pay for interest is higher than any lost investment earnings taking out the 401(k) loan can actually boost your savings for retirement. Be aware that this could decrease your personal (non-retirement) saving.

Stock Market Myths

The discussion above leads us to discuss a different (erroneous) assertion about 401(k) loans: By taking money out, you’ll dramatically impede the performance of your portfolio and the development of your retirement savings. It’s not always the case. First of all, as mentioned above, you will pay back the money, and you begin to do so in a short time. With the long-term outlook of the majority of 401(k)s that’s a rather small (and financially irrelevant) interval.4

19%

The percentage in 401(k) participants with outstanding loans in the year 2016 (latest information) as per an investigation 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 portfolio that’s geared toward growth that’s weighed toward equities will have fluctuations and ups, particularly in the short-term.

If your 401(k) is investing in stocks, the true effect on shorter-term loans to your retirement plan will depend on the current market conditions. The impact is likely to be mildly negative in markets that are booming but it could be neutral or positive, in sideways or down markets.

The bad but positive news: the best time to take an loan would be when you believe the stock market is vulnerable or weakening, such as during recessions. Many people discover that they need funds or to remain liquid in these periods.

Debuting Myths With Facts

There are two additional popular arguments that are made against 401(k) loans: The loans aren’t tax efficient and can cause huge difficulties when people are unable to pay them off before leaving work or retiring. Let’s tackle these myths with facts:

Tax Inefficiency

The claim the claim is 401(k) loans are tax-inefficient due to the fact that they must be repaid with after-tax dollars, subjecting loan repayment to double taxation. Only the part of the repayment that is financed by interest is subject to this treatment. The media usually ignore the fact that the price of double taxation of loan interest is usually low, when compared to cost of alternative ways to tap short-term liquidity.

Here’s a scenario that is often real: Imagine that Jane has been making steady retirement savings by deferring 7% of her salary to your 401(k). However, she’ll require a withdrawal of $10,000 to pay for a college tuition bill. She anticipates that she can pay back this amount with her earnings in around an entire year. She is in a 20% tax bracket for both the state and federal. Here are three ways she could access the cash:

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

Borrow from the bank at a real interest rate of 8.8%. The interest rate would be around $800.

Stop making 401(k) plan deferrals over the course of a year, and use the cash to pay for her tuition at college. In this scenario she’ll forfeit her savings from retirement, have to pay more income tax in the current year, and potentially forfeit any employer-matching contribution. It could cost up to $1,000.

The double-taxation associated with 401(k) loan interest becomes an important expense only when substantial amount are borrowed and 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 plan deferrals.

Leaving Work With an Unpaid loan

Suppose you take a plan loan and then go through a job loss. You will have to repay the loan in full. If you don’t pay the entire remaining loan balance will be considered a tax-deductible distribution and you could also face an additional 10% federal tax penalty on the unpaid balance when you’re under the age of 59 1/2 .6 Although this is an accurate description of the tax laws, it doesn’t always reflect reality.

At retirement or separation from employment, many people often opt to receive a portion from their 401(k) funds as a tax-deductible distribution especially if they are cash-strapped. Having an unpaid loan balance has similar tax implications to taking this decision. Most plans do not require plan distributions upon retirement or the disengagement from service.

People who want to avoid tax penalties can use other sources to repay the 401(k) loans before taking an income distribution. If they do this the entire balance of the plan can qualify for a tax-advantaged transfer or rollover. If the unpaid loan account is included within the participants taxable income, and the loan is then repaid the 10% penalty is not applicable. apply.7

The bigger issue is to take 401(k) loans while working with no intention or capacity to pay them according to a schedule. In this situation, the unpaid loan amount is treated similar to a hardship withdrawal with tax consequences that can be negative, and perhaps also an unfavorable impact on the rights of plan participants.

401(k) Loans to Purchase a Home

Regulations stipulate that 401(k) plan loans to be paid back using an interest-based basis (that is, with a set repayment schedule with regular installments) for a minimum of five years unless it is the case that the loan is used to buy a primary residence. Longer payback periods are allowed for these specific loans. The IRS does not specify the length 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 due to the CARES bill.2

Also, remember that CARES increased the amount that members can take out of their plans up to $100,000. Previously, the maximum amount that participants may borrow from their plan is 50 percent of their balance of their vested account or $50, depending on what amount is less. If the vested account balance is less than $10,000, you are still able to borrow up to $10,000.2

The option of borrowing from the 401(k) to fully finance the purchase of a home might not be as appealing as a mortgage loan. Plan loans do not offer tax-free interest payments, as do most types of mortgages. And, while the ability to withdraw and pay back within five years is fine in the usual scheme for 401(k) things however, the effect on your retirement goals for the loan that must be paid back over a number of years could be significant.

However an 401(k) loan might work for you if you require immediate cash to pay for the down payment or closing costs for a home. It won’t impact your ability to qualify for a mortgage either. Because it’s a 401(k) loan isn’t technically an obligation–you’re taking out your own funds at the end of the day, so it doesn’t have any influence on your debt-to-income ratio or on your score on credit, two major factors that influence the lenders.

If you are in need of an amount of money to buy a house and want to make use of 401(k) funds it is possible to look into a hardship withdrawal in lieu of, or as an alternative to the loan. However, you’ll be liable for an income tax for the cash withdrawal, and, if the amount is greater than $10,000, you will be subject to a 10% penalty is due as well.7

The Bottom Line

The argument regarding 401(k) loans «rob» or «raid» retirement accounts usually include two flaws They assume that they will always have high returns on stocks in the 401(k) portfolio but fail to consider the cost of interest when 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 an excellent liquidity option that is included within your 401(k) scheme. If you are able to borrow the right amounts of money for right short-term reasons they can be the simplest, most efficient, and least expensive option for cash. Before you take any loan it is essential to have a clear plan in mind for repaying these amounts in a timely manner or sooner.

Mike Loo, vice president of wealth management at Trilogy Financial, puts it this way «While your circumstances when taking a 401(k) loan may vary however, one way to prevent the downsides of getting one at all is to take preventive measures. If you’re able to make the effort to plan, set financial goals for yourself and make a commitment to save some money often and at an early time, you may find that you have the funds available to you in a different account from your 401(k) which will eliminate the need to take an 401(k) loan.»

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