401k Loans: A Good Idea, Or Costly Mistake?
We have all been there. Life happens. We have a big expense and we need cash quickly. This could be anything from a family emergency, to overwhelming credit card debt or a home remodel. The question for an individual or a family is always how to pay for the expense. You call your bank and hear about their personal unsecured loan “special” at only 8% or more. You look at your bank account and you may think that you just do not want to deplete your cash reserves for this expense. Then you think about that big pot of money in the company 401k plan that has been for the most part out of sight, out of mind. You wonder if you could use those funds for your immediate needs. You hear about the concept of a 401k loan and ask yourself if this is a good idea or not. Here are some pros and cons that may better inform you about this concept.
Positives of a 401k Loan
Let us start with the positives of borrowing money from your company 401k. If you are an active employee and have a balance in your 401k, some plans give their employees the option to borrow. While every 401k plan can be different, generally speaking, you can borrow up to 50% of your vested account balance, up to $50,000. For example: if your vested balance is $50,000 you can borrow $25,000. If your balance is $500,000 you can borrow $50,000. You receive the funds fairly quickly in most cases and you will begin to make payments on this loan with interest. You are removing funds from the plan and paying the funds back to yourself with interest through payroll deductions. The interest rate will be some nominal rate based on current interest rates that the plan sets.
You can generally borrow for up to 5 years with some exceptions. So, for example, if you take a loan out for $10,000 for 5 years at 5% interest, the payment will be $188.71 per month. If you get paid twice per month, you will have a $94.36 payroll deduction for each pay period over the next 5 years. You can usually pay off the loan early if you have the funds to do so. The funds go right back into your 401k as per your fund allocation instructions that are on file.
There are no credit implications for a 401k loan, meaning you don’t have to submit to a credit check. After all, you are borrowing from yourself.
Negatives of a 401k Loan
The first negative about a 401k loan is that the money is no longer in the 401k plan. A 401k is an investment plan intended for retirement. You can assume a certain level of growth over a long period of time if invested properly. The funds that you just borrowed are not in the plan and no longer working for you. They will be put back in slowly over time, but you may have missed out on some earning power during that time. That may make a substantial difference over an investing career of 20 or 30 years.
You may have heard that 401k loans are “taxed twice”. This is true. Assuming your 401k is all pre-tax, the contributions that you made came out of your paycheck before they were taxed. They are allowed to grow tax-deferred in the 401k. This means that you are “deferring” taxes on this money until you actually withdraw it, presumably in retirement. At this time, you will pay tax on whatever you withdraw. What causes the double tax on loans is this: you pay the loan money back to yourself with after tax money. Yes, that’s right. The loan repayment is made with after-tax withholding from your paycheck. The after-tax loan repayments actually go back in as pre-tax dollars. Then, in retirement, when you go to withdraw money for living expenses, you will pay tax again on that money. You may say that is a small price to pay for convenience and access to the funds, but that is a factor.
Because loan payments are paid back from payroll deductions, what happens if you leave the company and still have an outstanding balance? Some plans will issue you a coupon book to be able to continue sending in payments. Some plans just give you a certain amount of time to pay back the loan and then the loan will “default”. That sounds like a nasty term, but with a default, there are no credit implications. It simply means that the entire amount that is outstanding at the time of default will be considered taxable as ordinary income. You will receive a 1099R from the 401k plan for your taxes. If you are under 59 and 1/2, there could also be a 10% early withdrawal penalty on the outstanding balance. If you decide that you want to rollover your 401k to an IRA or new employer’s plan after leaving the company, this will usually automatically default the loan.
Some plans will only allow 1 loan to be outstanding at a time. If you need to take a second loan out and that is not an option, you will need to pay back the first loan, allow for some processing time and then take out another one. Some will allow many loans outstanding at once. You will need to check with your plan to see what they allow.
In conclusion, 401k loans are a convenient way to get needed funds quickly. However, the payroll deductions can be a burden to you as you are paying it back. If you change jobs, you will need to be prepared for a taxable event if you are not able to pay it back. You may also miss out on earnings had the funds never been borrowed. If you do it once, you may be tempted to do it again down the road, almost treating your retirement savings as a bank. This will impact your retirement savings. For some it may be a better option to seek a conventional loan from a bank, or better yet, save for your purchase and pay cash for it when you are ready. Only you can decide which option is best for you.
This information is intended for educational purposes only. It is not intended as investment advice. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. All expressions of opinion are subject to change. Investors should consult with a financial professional before making any investment decision.