401K Loans: Pros vs Cons
There are a number of pros and cons associated with taking a loan from your 401K plan. There are definitely situations where taking a 401(k) loan makes sense but there are also number of situations where it should be avoided.
There are a number of pros and cons associated with taking a loan from your 401K plan. There are definitely situations where taking a 401(k) loan makes sense but there are also number of situations where it should be avoided. Before taking a loan from your 401(k), you should understand:
How 401(k) loans work
How much you are allowed to borrow
Duration of the loans
What is the interest rate that is charged
How the loans are paid back to your 401(k) account
Penalties and taxes on the loan balance if you are laid off or resign
How it will impact your retirement
Sometimes Taking A 401(k) Loan Makes Sense
People are often surprised when I say “taking a 401(k) loan could be the right move”. Most people think a financial planner would advise NEVER touch your retirement accounts for any reasons. However, it really depends on what you are using the 401(k) loan for. There are a number of scenarios that I have encountered with 401(k) plan participants where taking a loan has made sense including the following:
Need capital to start a business (caution with this one)
Resolve a short-term cash crunch
Down payment on a house
Payoff high interest rate credit cards
Unexpected health expenses or financial emergency
I will go into more detail regarding each of these scenarios but let’s do a quick run through of how 401(k) loans work.
How Do 401(k) Loans Work?
First, not all 401(k) plans allow loans. Your employer has to voluntary allow plan participants to take loans against their 401(k) balance. Similar to other loans, 401(k) loans charge interest and have a structured payment schedule but there are some differences. Here is a quick breakout of how 401(k) loans work:
How Much Can You Borrow?
The maximum 401(k) loan amount that you can take is the LESSER of 50% of your vested balance or $50,000. Simple example, you have a $20,000 vested balance in the plan, you can take a 401(K) loan up to $10,000. The $50,000 limit is for plan participants that have balances over $100,000 in the plan. If you have a 401(k) balance of $500,000, you are still limited to a $50,000 loan.
Does A 401(k) Loan Charge Interest?
Yes, 401(k) loans charge interest BUT you pay the interest back to your own 401(k) account, so technically it’s an interest free loan even though there is interest built into the amortization schedule. The interest rate charged by most 401(k) platforms is the Prime Rate + 1%.
How Long Do You Have To Repay The 401(k) Loan?
For most 401(k) loans, you get to choose the loan duration between 1 and 5 years. If you are using the loan to purchase your primary residence, the loan policy may allow you to stretch the loan duration to match the duration of your mortgage but be careful with this option. If you leave the employer before you payoff the loan, it could trigger unexpected taxes and penalties which we will cover later on.
How Do You Repay The 401(k) Loan?
Loan payments are deducted from your paycheck in accordance with the loan amortization schedule and they will continue until the loan is paid in full. If you are self employed without payroll, you will have to upload payments to the 401(k) platform to avoid a loan default.
Also, most 401(K) platforms provide you with the option of paying off the loan early via a personal check or ACH.
Not A Taxable Event
Taking a 401(k) loan does not trigger a taxable event like a 401(k) distribution does. This also gives 401(k)’s a tax advantage over an IRA because IRA’s do not allow loans.
Scenarios Where Taking A 401(k) Loans Makes Sense
I’ll start off on the positive side of the coin by providing you with some real life scenarios where taking a 401(k) loan makes sense, but understand that all of the these scenarios assume that you do not have idle cash set aside that could be used to meet these expenses. Taking a 401(k) loan will rarely win over using idle cash because you lose the benefits of compounded tax deferred interest as soon as you remove the money from your account in the form of a 401(k) loan.
Payoff High Interest Rate Credit Cards
If you have credit cards that are charging you 12%+ in interest and you are only able to make the minimum payment, this may be a situation where it makes sense to take a loan from your 401(k) and payoff the credit cards. But………but…….this is only a wise decision if you are not going to run up those credit card balances again. If you are in a really bad financial situation and you may be headed for bankruptcy, it’s actually better NOT to take money out of your 401(k) because your 401(k) account is protected from your creditors.
Bridge A Short-Term Cash Crunch
If you run into a short-term cash crunch where you have a large expense but the money needed to cover the expense is delayed, a 401(k) loan may be a way to bridge the gap. A hypothetical example would be buying and selling a house simultaneously. If you need $30,000 for the down payment on your new house and you were expecting to get that money from the proceeds from the sale of the current house but the closing on your current house gets pushed back by a month, you might decide to take a $30,000 loan from your 401(k), close on the new house, and then use the proceeds from the sale of your current house to payoff the 401(k) loan.
Using a 401(k) Loan To Purchase A House
Frequently, the largest hurdle for first time homebuyers when planning to buy a house is finding the cash to satisfy the down payment. If you have been contributing to your 401(k) since you started working, it’s not uncommon that the balance in your 401(k) plan might be your largest asset. If the right opportunity comes along to buy a house, it may makes sense to take a 401(k) loan to come up with the down payment, instead of waiting the additional years that it would take to build up a down payment outside of your 401(k) account.
Caution with this option. Once you take a loan from your 401(k), your take home pay will be reduced by the amount of the 401(k) loan payments over the duration of the loan, and then you will a have new mortgage payment on top of that after you close on the new house. Doing a formal budget in advance of this decision is highly recommended.
Capital To Start A Business
We have had clients that decided to leave the corporate world and start their own business but there is usually a time gap between when they started the business and when the business actually starts making money. It is for this reason that one of the primary challenges for entrepreneurs is trying to find the capital to get the business off the ground and get cash positive as soon as possible. Instead of going to a bank for a loan or raising money from friends and family, if they had a 401(k) with their former employer, they may be able to setup a Solo(K) plan through their new company, rollover their balance into their new Solo(K) plan, take a 401(k) loan from their new Solo(k) plan, and use that capital to operate the business and pay their personal expenses.
Again, word of caution, starting a business is risky, and this strategy involves spending money that was set aside for the retirement years.
Reasons To Avoid Taking A 401(k) Loan
We have covered some Pro side examples, now let’s look at the Con side of the 401(k) loan equation.
Your Money Is Out of The Market
When you take a loan from your 401(k) account, that money is removed for your 401(k) account, and then slowly paid back over the duration of the loan. The money that was lent out is no longer earning investment return in your retirement account. Even though you are repaying that amount over time it can have a sizable impact on the balance that is in your account at retirement. How much? Let’s look at a Steve & Sarah example:
Steve & Sarah are both 30 years old
Both plan to retire age 65
Both experience an 8% annualize rate of return
Both have a 401(K) balance of $150,000
Steve takes a $50,000 loan for 5 years at age 30 but Sarah does not
Since Sarah did not take a $50,000 loan from her 401(k) account, how much more does Sarah have in her 401(k) account at age 65? Answer: approximately $102,000!!! Even though Steve was paying himself all of the loan interest, in hindsight, that was an expensive loan to take since taking out $50,000 cost him $100,000 in missed accumulation.
401(k) Loan Default Risk
If you have an outstanding balance on a 401(k) loan and the loan “defaults”, it becomes a taxable event subject to both taxes and if you are under the age of 59½, a 10% early withdrawal penalty. Here are the most common situations that lead to a 401(k) loan defaults:
Your Employment Ends: If you have an outstanding 401(K) loan and you are laid off, fired, or you voluntarily resign, it could cause your loan to default if payments are not made to keep the loan current. Remember, when you were employed, the loan payments were being made via payroll deduction, now there are no paychecks coming from that employer, so no loan payment are being remitted toward your loan. Some 401(k) platforms may allow you to keep making loan payments after your employment ends but others may not past a specified date. Also, if you request a distribution or rollover from the plan after your have terminated employment, that will frequently automatically trigger a loan default if there is an outstanding balance on the loan at that time.
Your Employer Terminates The 401(k) Plan: If your employer decides to terminate their 401(k) plan and you have an outstanding loan balance, the plan sponsor may require you to repay the full amount otherwise the loan will default when your balance is forced out of the plan in conjunction with the plan termination. There is one IRS relief option in the instance of a plan termination that buys the plan participants more time. If you rollover your 401(k) balance to an IRA, you have until the due date of your tax return in the year of the rollover to deposit the amount of the outstanding loan to your IRA account. If you do that, it will be considered a rollover, and you will avoid the taxes and penalties of the default but you will need to come up with the cash needed to make the rollover deposit to your IRA.
Loan Payments Are Not Started In Error: If loan payments are not made within the safe harbor time frame set forth by the DOL rules, the loan could default, and the outstanding balance would be subject to taxes and penalties. A special note to employees on this one, if you take a 401(k) loan, make sure you begin to see deductions in your paycheck for the 401(k) loan payments, and you can see the loan payments being made to your account online. Every now and then things fall through the cracks, the loan is issued, the loan deductions are never entered into payroll, the employee doesn’t say anything because they enjoy not having the loan payments deducted from their pay, but the employee could be on the hook for the taxes and penalties associated with the loan default if payments are not being applied. It’s a bad day when an employee finds out they have to pay taxes and penalties on their full outstanding loan balance.
Double Taxation Issue
You will hear 401(k) advisors warn employees about the “double taxation” issue associated with 401(k) loans. For employees that have pre-tax dollars within their 401(k) plans, when you take a loan, it is not a taxable event, but the 401(k) loan payments are made with AFTER TAX dollars, so as you make those loan payments you are essentially paying taxes on the full amount of the loan over time, then once the money is back in your 401(k) account, it goes back into that pre-tax source, which means when you retire and take distributions, you have to pay tax on that money again. Thus, the double taxation issue, taxed once when you repay the loan, and then taxed again when you distribute the money in retirement.
This double taxation issue should be a deterrent from taking a 401(k) loan if you have access to cash elsewhere, but if a 401(k) loan is your only access to cash, and the reason for taking the loan is justified financially, it may be worth the double taxation of those 401(k) dollars.
I’ll illustrate this in an example. Let’s say you have credit card debt of $15,000 with a 16% interest rate and you are making minimum payments. That means you are paying the credit card company $2,400 per year in interest and that will probably continue with only minimum payments for a number of years. After 5 or 6 years you may have paid the credit card company $10,000+ in interest on that $15,000 credit card balance.
Instead, you take a 401(k) loan for $15,000, payoff your credit cards, and then pay back the loan over the 5-year period, you will essentially have paid tax on the $15,000 as you make the loan payments back to the plan BUT if you are in a 25% tax bracket, the tax bill will only be $3,755 spread over 5 years versus paying $2,000 - $2,500 in interest to the credit card company EVERY YEAR. Yes, you are going to pay tax on that $15,000 again when you retire but that was true even if you never took the loan.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
