When you need a 401(k) loan is a good idea, it makes sense.
401(k) Loan Basics
The 4 most compelling reasons to borrow
Stock Market Myths
Debuting Myths With Facts
401(k) loans to purchase a Home
The Bottom Line

Retirement Plan 401(k)

4 Reasons to Borrow from Your 401(k)

When is the best time to get a 401(k) loan? When the stock market is in a downtrend
By Troy Segal
Updated January 25, 2022
Review by David Kindness
The factual information is verified by Skylar Clarine
Skylar Clarine

The financial media has coined some snarky phrases to describe the pitfalls when borrowing funds from the 401(k) scheme. Some--including financial planning professionals--would even suggest that taking a loan from a 401(k) program is an act of theft against your retirement.

However, it is true that a 401(k) loan can be suitable in certain situations. Let's take a look at how such loan loan could be utilized wisely and also why it shouldn't be a problem in your financial savings.
Key Takeaways

If done with the proper reasons, taking the short-term 401(k) loan and paying the amount back in time isn't necessarily a bad option.
Some of the reasons to borrow money from your 401(k) include speed and convenience as well as repayment flexibility as well as cost savings, and possible advantages for your savings during a down market.
Common reasons against taking a loan are negative effects on performance in the investment market, tax efficiency and the fact that quitting a job with an unpaid loan can have unintended consequences.
A down market for stocks could be one of the best times to apply for an 401(k) loan.

If a 401(k) Loan Makes Sense

If you're looking for funds for a critical immediate liquidity issue, a loan taken from your 401(k) plan is likely to be one of the first places to look. Short-term is defined as at least a year. Let's define "serious liquidity need" as a serious one-time demand 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 explained it in this manner: "Let's face it, in the real world, sometimes people require cash. Borrowing out of your 401(k) is financially smarter as opposed to taking out a costly high-interest title loan, pawn, or payday loan, or even a sensible personal loan. It will cost you less in the longer term. "1

Why is you 401(k) an appealing source for short-term loans? Because it is the most efficient, simple, and most affordable way to access the money you require. A loan through your 401(k) isn't a taxable event unless the loan restrictions and repayment guidelines are not followed, and it will not impact your credit score.

If you repay a short-term loan according to the timeframe typically, it won't have any impact on the progress of your retirement savings. In fact, in some cases, it can even have a positive impact. Let's look a bit deeper to explain why.
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401(k) Basics of a Loan

Technically speaking, 401(k) loans are not real loans as they do not involve either an appraisal by a bank or a review of your credit background. They can be better described as the ability to gain access to a certain amount of your own retirement plan funds--usually, at least $50,000, or 50% your total assets or less--on an untaxed basis.2 You must then repay the money you have access to under rules that are designed to return you and your 401(k) program to the same condition like if the transaction has not taken place.

Another confounding aspect of these transactions is the term interest. The interest on the remaining loan balance is repaid by the participant into the participant's own 401(k) account, which means that technically, it is an exchange from one pocket to another, and not a borrowing expense or loss. Therefore, the impact of a 401(k) loan on your savings for retirement could be low, neutral, or even positive. However, in the majority of cases, it'll be lower than paying interest on a personal or commercial loan.
How to Become a 401(k) Millionaire
The Top 4 Reasons to Borrow from Your 401(k)

The top four reasons to turn at your 401(k) for urgent short-term cash needs are:
1. Speed and Convenience

In most 401(k) plan, requesting an loan is easy and fast, requiring no lengthy requests and credit check. Normally, it does not cause an inquiry to your credit or affect your credit score.

A lot of 401(k)s allow loan request to be submitted with just a few clicks on a website, and you can have funds available in several days, while maintaining absolute confidentiality. One of the latest innovations being embraced by some plans is a debit card, that allows multiple loans can be made immediately in tiny amounts.3
2. Repayment Flexibility

Although the regulations stipulate the amortization schedule for five years, for most 401(k) loans, you can pay back the loan faster with no prepayment penalty.2 The majority of plans permit loan repayment to be paid conveniently through payroll deductions--using after-tax dollars, though, not the pretax ones funding your plan. Your statements from your plan will show the amount of credit to your loan account as well as your outstanding principal balance exactly like a regular bank loan statement.
3. Cost Advantage

There's no cost (other aside from perhaps a small loan origination or administration fee) to draw on your own 401(k) money to meet immediate liquidity requirements. This is how it operates:

You select an investments account(s) from which you'd like to borrow money, and the investments are liquidated for the time period of your loan. Therefore, you lose any gains that would have been earned by these investments over a brief period. In the event that the market is in decline, you are selling these investments for less than at other times. The upside is that you also avoid any future losses to your investment cash.

The benefit of the 401(k) loan is the equivalent to the interest rate charged on similar consumer loan minus any lost capital gains on the principal amount you borrowed. This is a straightforward formula:

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

Let's say you could apply for a personal loan or take a cash advance with a credit card at the rate of 8. You're 401(k) investment portfolio could be earning 5 percent return. The cost benefit of using the 401(k) plan is 3% (8 5 x 8 is 3).

When you know that the cost benefit will be positive in the long run, the plan loan could be appealing. Be aware that this calculation ignores any tax impact that could increase the benefits of a plan loan since consumer loan interest is repaid with tax-free dollars.
4. Retirement Savings Can Benefit

If you make loan payments to the 401(k) account typically, they are redirected back into your portfolio's investments. You'll have to repay the account in a little more than the amount the amount you borrowed, and this is referred to as "interest." The loan produces no (that is to say that it has no) effect on retirement plan if lost investment earnings match the "interest" paid in--i.e., earnings opportunities are offset dollar-for-dollar by interest payments.

If the amount you pay for interest is higher than the lost investment earnings taking out a 401(k) loan can actually boost your savings for retirement. Keep in mind that this could reduce the amount of your individual (non-retirement) funds.
Stock Market Myths

The discussion above leads us to discuss a different (erroneous) claim about 401(k) loans: By taking money out, you'll dramatically impede the performance of your portfolio and the development of your retirement savings. That's not necessarily true. In the first place, as mentioned above, you will repay the funds, and you begin doing it very quickly. With the long-term outlook of the majority of 401(k)s this is a fairly small (and financially irrelevant) interval.4
19%

The proportion of 401(k) participants with outstanding loans during 2016 (latest information) as per an analysis 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 growth-oriented portfolio that's weighted toward equities will have ups and downs, especially in the short term.

In the event that you have a 401(k) is comprised of stocks, the effect on the short-term loans to your retirement progress will be contingent upon the market conditions. The impact should be modestly negative in strong up markets however it could be neutral, or even positive, in sideways or down markets.

The bad but positive information: the most appropriate time to apply for a loan is when you believe that the market is at risk or weakening, for instance during recessions. In the course of time, many find that they need funds or liquid funds in these periods.
Debunking Myths With Facts

There are two other popular arguments that are made against 401(k) loans: The loans aren't tax efficient and cause a lot of difficulties when people are unable to repay them before leaving work or retiring. Let's tackle these myths with facts:
Tax Inefficiency

The argument to be true is 401(k) loans are tax-inefficient due to the fact that they must be repaid with after-tax dollars, subjecting loan repayment to taxation double. Only the interest portion of the repayment is subject to such treatment. The media usually ignore the fact that the price of double taxation of loan interest is usually small, compared with the costs of other ways to access liquidity in the short term.

Here's a scenario that is too often very real: Let's say Jane is able to make steady savings by deferring the 7% of her income in the 401(k). But, she'll need to tap $10,000 to pay for cost of tuition for her college. She expects to pay this loan back with her earnings in around a year. She is in the 20% combined tax bracket for both the state and federal. Three ways she can tap the cash:

Take a loan out of the funds in her 401(k) with an "interest rate" of 4.4%. Her cost of double-taxation on the interest amount is the amount of $80 ($10,000 loan x 4% interest x 20% tax rate).
You can borrow money from the bank at a real interest rate of 8percent. The cost of interest is $800.
Do not make 401(k) plans deferrals for a year and use the money to pay her tuition to college. In this situation she'll forfeit her retirement savings progress, pay higher current income tax as well as be unable to receive any employer-matching contributions. It could cost up to $1,000.

Taxation on double taxation for 401(k) loan interest becomes an important expense only when large amounts are borrowed , and later paid back over a long period of time. Even so, it generally is less expensive than other options for accessing similar amounts of cash via bank or consumer loans or a pause in deferrals from the plan.
Resigning from Work with an unpaid Loan

Imagine you take out a loan and then go through a job loss. Then you must repay the loan in total. If you fail to do so then the total not paid loan amount is considered a taxable distribution, and you may also be subject to a 10% federal tax penalty on the unpaid balance when you're under the age of at 59 1/2 .6 Although this is an accurate representation of taxes, the law doesn't necessarily reflect the reality.

At retirement or separation from employment, many people often choose to take part or all of the 401(k) money as a tax-deductible distribution especially if they are cash-strapped. Having an unpaid loan balance comes with the same tax consequences as taking this decision. Most plans do not require plan distributions at retirement or disengagement from service.

People who want to avoid negative tax consequences should consider tapping other sources to pay off the 401(k) loans before taking an income distribution. If they do then the total balance can qualify for a tax-advantaged transfer or rollover. If an not paid loan amount is included as part of the plan participant's tax-deductible income, and the loan is then repaid the penalty of 10% does not apply.7

The most serious issue is when you take 401(k) loans while working without having the intent or the ability to pay them back according to a schedule. In this scenario, the not paid loan amount is treated similar to a hardship withdrawal which can have tax implications that are negative and, possibly, an unfavorable impact on plan participation rights.
401(k) Loans to Purchase the Home of your choice

Regulations stipulate that 401(k) plan loans to be paid back using an interest-based basis (that is, with a fixed repayment plan in regular installments) over not more than five years, unless they are loan is used to buy the primary residence. Payback times that are longer are permitted for these loans. The IRS does not specify the length the payback period will be, however, it's something you'll have to negotiate with your plan's administrator. Also, ask if you can get an additional year due to the CARES bill.2

Also, remember that CARES extended the amount the participants are able to take out of their plans up to $100,000. Previously, the maximum amount that plan members could borrow from their plan is 50 percent of their account's vested balance or $50,000, whichever amount is less. If your vested account balance is lower than $10,000, you can still borrow up to $10,000.2

A loan from a 401(k) to completely finance the purchase of a home might not be as appealing as taking out an mortgage loan. Plan loans don't provide tax deductions for interest payments unlike the majority of mortgages. While withdrawing and repaying within five years is acceptable within the typical framework of 401(k) things but the impact on your retirement plan for the loan that has to be paid back over many years could be significant.

However, a 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 affect your qualifying for a mortgage, either. Since the 401(k) loan isn't technically a debt--you're withdrawing your own money and, in the end, it has no effect on your debt-to-income ratio or your score on credit, two big elements that affect lenders.

If you need to borrow a sizable sum to purchase a house and want to make use of 401(k) funds it is possible to think about a hardship withdrawal instead of, or as an alternative to, the loan. However, you'll be liable for income tax on the withdrawal, and in the event that the withdrawal amount is greater than $10,000, a 10% penalty is due as well.7
The Bottom Line

Arguments regarding 401(k) loans "rob" or "raid" retirement accounts often include two flaws: They assume constantly high returns on stocks in the 401(k) portfolio but fail to consider the costs of borrowing similar amounts through the bank or other loans (such as racking up credit card balances).

Don't be afraid of the possibility of a beneficial liquidity option within the 401(k) program. When you borrow appropriate amounts of money for appropriate short-term goals, these transactions can be the easiest, most convenient, and lowest-cost option for cash. Before you make any loan, you should always have a plan in your mind to repay these loans on schedule or earlier.

Mike Loo, vice president of wealth management at Trilogy Financial, puts it this way "While the circumstances of a person who needs to take a 401(k) loan may vary but a way to stay clear of the downsides of getting one in the first place is preemptive. If you can plan ahead and set goals for your financial future and make a commitment to save some money often and early it is possible that you have money in an account other than your 401(k), thereby preventing the necessity of taking an 401(k) loan."
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