401K Loan Rules – Taxes, Interest, Pros and Cons

401k Loan Rules allow for easy access to retirement funds, but is that a good thing?  Many employees are unaware that they can take a loan from their 401k account for basically any personal need with very little hassle.  There are clear negative attributes to this route, but some situations may warrant considering this option, depending on the need and other options at your disposal.  One major misunderstanding is how the loan works and how it is administered.

How Much Can You Borrow From Your 401K?

Most 401k plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less. Many plans allow immediate vesting, but if not, you’ll want to ensure you understand what your vested amount is.  You usually have up to five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback.  You can basically use the funds for whatever you want.  If you adhere to the confines of these rules, you don’t need to pay the 10% early withdrawal distribution penalty since you’re paying it back within the confines of the plan.

Where Does 401K Loan Interest Go?

This is an oft-misunderstood and misrepresented question depending on which site you hit on the internet.  Based on personal experience (more on that below), the interest paid actually goes back into your own 401k account – so you’re paying it back to yourself.  You are NOT paying to the administrator, to the government or to anyone other than yourself.  You might question why there’s an interest rate at all then.  It’s basically to deter complete abuse of the provision to borrow money interest-free that was already exempted from income tax when you contributed to your account.  Suze Orman and others have also purported that borrowing from your 401K creates some sort of “double-taxation”.  While it’s a rather complex consideration of ifs, thens, and competing scenarios, perhaps it’s better stated that the interest is not tax-deductible like other options such as a HELOC, but I don’t agree that the amount borrowed is “double-taxation” by any means.  Depending on your frame of reference, one may consider the interest portion as double-taxed because you’re paying back that interest to yourself in a tax-deferred account with after tax money, and then it will be taxed in retirement – But…But – the interest portion is a marginal amount of money compared to the amount borrowed since it is often offered at below market borrowing rates.

So, let’s consider the context.  If you borrow $20,000 at 4% and pay if back over a couple years, the total interest is a few hundred dollars.  Tax on a few hundred dollars is approaching a measley $100.  Is this really worth micro-analyzing if you actually need the $20,000 for something important?  It’s less than 1% of the total amount borrowed, so it’s less than a typical annual expense ratio on many funds you’re in, or certainly less than the fees/interest on ANY conventional loan you’ll ever come across.

Where else could you borrow $20,000 for $100 and pick the payback term?

The Case FOR 401k Loans

• It’s Your Money!  If you need it for an emergency or some compelling reason, you can stop the clock on your retirement funding, withdraw it and pay it back.
• The interest rate is usually quite low generally at around 5% or less during the past several years. And you pay the interest back to yourself.  The net loss due to the “double taxation” of interest is marginal.
• There is no credit check required (see why credit score is critical) and the transaction can usually executed within a week or two.  This is much faster than most other loan options.

The Case AGAINST 401k Loans

• It’s Too Easy!  The ease of which one can withdraw the funds lends itself to bad behavior.  If people are already reckless with their personal finances by spending more than they take in by financing a lifestyle with credit card debt, what’s to stop them from drawing down the 401k in similar fashion?
• You may miss out on a great market run.  While you’re spending that money, it could have been growing your account principal.
• If you are unable to pay back the loan, it is considered a premature 401k plan distribution.  If you are laid off or leave your job, you may have to pay back the loan in full immediately as well.  Otherwise, you will owe federal and state income taxes in addition to the 10% penalty if you are under age 59 1/2.
• Sporadically tapping the 401k could seriously impede your retirement goals.  Doing this under extremely rare circumstances throughout an entire career is one thing.  But taking a loan for each summer vacation and paying it back over the next year is likely to be detrimental to your long term returns.

Why Would You EVER Borrow from your 401k?

There are certain life situations that may warrant tapping your 401k account because the alternative is even less desirable.  These circumstances may include being laid off or an unforeseen medical emergency that consumed your emergency funds.  If your options are to stop paying the mortgage and face eviction, embrace payday loans, or take a 401k loan, it’s an obvious choice.  From another angle, what if a once in a lifetime investment opportunity came along?  Example – great real estate investment opportunity or a friend is selling a successful business for health reasons/retirement.  If it’s a low risk/high reward opportunity, and you’re confident you could handle the payback over time regardless of what happens to the initial funding, perhaps it’s a worthwhile endeavor.

Disclosure:  I Took Out a 401K Loan Myself

In my early 20’s, I took out a 401k loan.  I was newly employed and was getting engaged the same year I bought a house a year out of school.  I was making pretty good money for my age, as I had one of the highest paying degrees out of school and I employed sound money habits (I drove a piece of junk for years, had no other debt and all I did was work long hours).  I knew I could pay the loan back easily but I just hadn’t been working long enough to rebuild a large fund.  I had just purchased a home after all.  So, in looking at the pros and cons, I decided that rather than either a) propose to my would-be wife with a very meager stone or b) put off getting engaged/married for another year, I opted to fund a diamond I’d be proud to present with partial funding from a 401K loan.  While some may scoff at this as a “frivolous” or irresponsible use of 401K funds, I weighed the risks and given the modest amount I borrowed and the outcome, I don’t have any regrets.  As expected, I paid it back in a year, paid myself the interest, and as I recall, the market was roughly flat during the period, so I didn’t miss out on a spectacular stock market run.

When To or When NOT To is the Question

With that being said, I don’t think people should take this 401k loan option lightly.  Because it’s so easy to do, people are most certainly tempted to tap into those retirement funds for routine spending or frivolous reasons.  I mean, is tapping into the 401K any worse than carrying credit card debt?  At least with the 401K loan, the interest rate is generally 5% or under and the interest gets paid back directly to you.  With credit cards, you can pay upwards of 20% if you’re not in a 0% percent balance transfer.  Now, I’m not condoning both/either, but given the lesser of two undesirable sources of temporary income, the 401K loan isn’t looking so bad.

Do You Think It’s EVER Prudent to Take Out a 401K Loan?

Tagged as: 401k loan rules