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September 16, 2019

Taking a Loan from Your 401(k): Pros and Cons

For many people, their largest financial asset is their retirement savings.

The average 30-39 year-old has $42,400 in their 401(k) account while the average 40-49 year old has $102,700 saved (Fidelity Investments; Q1 2019). That’s no chump change, and sometimes those funds need to be tapped into. However, when it comes to taking a loan from your 401(k) plan, the overwhelming consensus on the topic is that one should never tap into their plan to access an available loan.

While that may be solid advice in a perfect world, the reality is that life happens and sometimes a plan participant may run into emergencies or have no other good alternatives when it comes to something such as making a down payment for a home.

With the understanding that one should consider other options before taking a loan from the 401(k), let’s take a look at the pros and cons of such a loan, cons first. 

Cons: Raiding Your Retirement Funds, Taxes and Penalties, Missing Out on Matching Contributions

There are two major drawbacks to taking a loan from your 401(k)-which center around the idea of raiding your retirement funds at worst, and at a minimum harming your long-term plan, even if the loan is fully repaid as scheduled.

One of the appeals of taking a loan is that you are able to pay it back and restore the money taken with interest, in such a situation you are not really raiding the retirement fund.

However, what many people don’t realize is if you leave the company before the loan is paid off (voluntary separation or involuntary makes no difference) the outstanding balance is due immediately.  Generally speaking, if you are in a position that you have an outstanding 401(k) loan in the first place, you will not be in a position to repay the balance should your employment end.

If you are not able to repay, the loan is considered in default and will be treated as a pre-mature taxable distribution. If this happens, you may get hit on two fronts:

Thus, someone carrying a $10,000 outstanding balance in a 25% marginal tax bracket (and younger than age 59 ½) would incur a tax liability of $3,500. It is important to understand the difference between your effective tax rate and your marginal tax rate. The effective tax rate is the overall percentage of taxable income you paid in taxes when all is said and done. The marginal rate is the rate you will be taxed on your next dollar of income. Given the nature of tax brackets, deductions and exemptions; the marginal rate will always be a higher rate than your effective rate. In the example above, even if a borrowers’ effective tax rate for a year is 16%, the real penalty incurred is 35% of the outstanding loan balance.

The second major drawback of taking out a 401(k) loan, applies even if the loan is paid back on time. Rules vary from plan to plan, but many will not allow a participant to continue making contributions to the plan while there is an outstanding loan, thus inhibiting your retirement savings. While you can still save money outside of the plan, you will not get the tax deferral benefit afforded by the 401(k). Further still, you will not be able to receive any matching contributions your company may make on your behalf. 

In this situation, while you have not raided your retirement account never to see the money again, your long-term plan is affected by the amount of money that is no longer contributed by you and your employer while the loan is outstanding. Again, it is important to remember that different plans have different rules. A potential borrower should understand if they will be able to continue contributions while the loan is outstanding.

Another thing many people fail to realize is that their 401(k) accounts are typically protected from creditors in the event of a bankruptcy. The issue is that individuals may borrow funds from their 401(k) in an attempt to get out of debt, then if they fail or stay in debt and declare bankruptcy, they just used up their once-protected retirement money all for nothing.

Pros: Paying Interest to Yourself, Lower Fees and Rates, and Encouraging Overall Retirement Plan Participation

The big benefit of taking a loan out from your 401(k) is that the interest you pay is paid back to yourself. When you are paying interest to yourself in your plan, that effectively means your investment (that you took out of the plan) is still getting a return.  In fact, in a well-diversified retirement plan portfolio, a portion of your investments will be in bonds, which are loans to governments and corporations. Thus, in one admittedly crude sense, your loan could be looked at as an investment choice in your plan (though it must be said the bond investments in your plan would carry a much lower risk profile).

Another benefit is that while there will be an administrative fee to process a loan from your plan, the overall expenses, including the interest rate and fees are likely to be much lower than taking another loan out, and certainly better than utilizing credit cards and associated fees and interest.

From an overall retirement planning perspective, perhaps the biggest benefit of using your 401(k) balance for a loan is the willingness to consider such an option in the first place.

This may seem counterintuitive especially as study after study shows that most Americans are not saving enough for retirement. But that begs the question: Why do people not contribute more to retirement savings?

Because they have, or anticipate, liquidity needs in the short-term. Of course, one should look at budgeting and not living beyond your means, but as mentioned earlier, the reality is that life happens, and even the best-laid plans can run into problems.

Having the reassurance that your 401(k) plan has a potential loan available greatly increases the likelihood that you will utilize the plan and partake in the all-important company matching contributions (if offered) which in turn, increases the likelihood of success in your long-term retirement plan. 

Different Answers for Different Situations

It is very easy for someone on the outside of a situation to dictate that one should never use the 401(k)-loan option. In an academic world, such advice makes perfect sense. But in real life, one’s options rarely boil down to take out a 401(k) loan or don’t take it and life goes on as normal. One considers taking such a loan in times of hardship or helping to pay for major, planned purchases such as buying a home. In these cases, a potential borrower should understand that taking a loan creates issues and potential liabilities, but it may be better than the alternatives.

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