The 401k Loan May Have Benefits, but it Isn’t Without Pitfalls
Roughly 75% of 401k plans have a loan provision. This is good news for participants who find themselves in a bind and need quick access to some cash, but it also potentially puts a lot of retirement nest eggs at risk. In fact, about 30% of employees who have the ability to take a loan from their 401k plan have done so and currently have an outstanding loan balance. This number picked up a bit during the economic downturn as people found themselves in difficult situations and in need of a little extra money.
In an ideal world we’d leave our retirement plans alone, rely on our emergency fund in a time of need, and continue adding the maximum 401k contribution. But let’s face it, life happens. As much as we try to plan ahead and put money aside for that very reason there are times when that just isn’t possible or those funds aren’t sufficient to cover a major crisis. So, having the ability to tap into your 401k a little early may be your saving grace. Unfortunately, it isn’t all sunshine and rainbows. Taking a loan against your 401k may have devastating consequences if you’re not careful and the decision to borrow from your retirement nest egg should not be taken lightly.
401k Loan Basics
While each plan may set their own specific loan features and restrictions there are a number of similarities. Even so, if you are considering a loan, be sure to check with your plan provider to see what the requirements are for you.
- Most plans have a minimum loan amount which is often $500 or $1,000. The good news is that this keeps people from taking small and frequent loans for things they can probably find the cash for elsewhere, but it also means you may need some time to repay the loan if it’s more than you actually need.
- Plans typically allow you to borrow up to 50% of your vested balance up to $50,000. Keep in mind that not all plans will allow you to borrow from the vested company match and it may restrict you to your personal vested balance. On the other hand, the available vested balance typically does include amounts rolled over into the 401k from an outside account.
- Personal loans have a maximum repayment term of five years, but most plans also allow home loans to be taken for the purchase of a new primary residence. Additional documentation may be required to prove the home purchase, but those loans generally have a 15-year term.
- In most cases your loan must be paid with equal installments taken directly from your paycheck over the life of the loan. Once the loan has been issued you usually can’t change the payment terms, although some plans do allow you to pay off the loan in full early.
- The interest rate is often set as the prime rate plus 1%. The loans use a fixed rate and will be set on the day the loan is issued.
- Loan origination fees may exist and you can expect to pay anywhere from $25 to $100 just to process the loan.
- Loans proceeds are not taxed at the time of the distribution, but would be taxed in the event of a default.
The Advantages of a 401k Loan
Don’t get me wrong, there are far worse things you can do in a time of need than borrow some money from your retirement account. Racking up credit card bills, getting your vehicle repossessed, home foreclosed upon, or resorting to payday loans are very bad alternatives. So, there are some situations in which a 401k loan has an advantage.
One of the best benefits is that there’s very little paperwork to fill out and most loans are issued regardless of your needs. With many plans it can be as easy as logging into your account online and clicking a few buttons to have a loan issued. It can then be sent in a few days via check or possibly even deposited directly into your checking account. And unless you’re requesting a loan for the purchase of a home, most plans don’t care why you’re asking for the money and you are under no obligation to tell them. Try getting a loan at the bank without filling out a mountain of paperwork or running a credit check. It won’t happen, so because of this simplicity the 401k loan has an advantage.
Let’s talk about interest. When you borrow money from a bank or charge something on a credit card you need to repay the loan plus interest. In these cases you pay the bank the interest. So, you may need to borrow $2,000 but after all said and done you may have shelled out $3,000 to pay off the balance. The bank just made off with $1,000 of your money. With a 401k loan you pay yourself the interest. If you borrow $2,000 from your account and interest charges over the life of the loan totaled $1,000 you actually put that extra $1,000 back into your 401k. Keep in mind that some of that money was paid back in with after-tax money, but the net result is far better than giving those finance charges to a bank or credit card company.
The Disadvantages of a 401k Loan
While a 401k loan clearly has some advantages over traditional borrowing, let’s not forget that there are plenty of disadvantages that should have you thinking twice before borrowing from 401k.
- Don’t ignore fees. These loans usually aren’t free, and as mentioned above there is typically a loan origination fee of anywhere up to $100. In addition, there may be an annual maintenance fee. If you are borrowing $1,000 and they charge you a $75 origination fee that’s 7.5% of the loan. If there’s an additional $25 annual maintenance fee and you require three years to repay the loan you just spent another 7.5%. That $1,000 loan that seemed like a good idea actually cost you $150 in fees, or 15%.
- If you default on your loan it won’t hurt your credit score, but it could be even more damaging to your finances. Defaults are treated as a distribution, which means your money is then taxed and you must also pay the 10% early withdrawal penalty if you’re under age 59.5. If you already spent the loan proceeds and wasn’t planning on having a major taxable event this could lead to big problems come April 15th.
- There’s also a significant opportunity cost when taking a loan. If you pull money out of your retirement account you’re pulling money out of the market and/or safe fixed accounts as well as temporarily eliminating the tax-deferred growth that money would have otherwise been earning.
- The market can also move between when you take a loan and when you repay it. If you’re unfortunate enough to take a loan while the market is at a bottom and then begins going back up you’ve done even more damage to your retirement account as you’ve cashed out some money at a low point and will be buying back in over the coming years while the market is high. Of course the opposite is also true, but this is a game you shouldn’t be playing with your nest egg.
- You are also repaying part of the loan with money that has already been taxed. As you know, one of the benefits of contributing to a 401k is the fact that the money is invested pre-tax. When you take a loan you aren’t taxed on the proceeds, but the money used to repay the loan has already been taxed so your additional interest going into the account will effectively be taxed twice–at the time of contribution and again when eventually withdrawn from the account in retirement.
Choosing Which Investments to Borrow Against
Some loans do not give you a choice and they will simply take an equal portion out of each investment to cover the loan proceeds. This means if you have 80% in stocks and 20% in a fixed account and request a $10,000 loan they will pull $8,000 from your stock holdings and 20% from your fixed account. If you don’t have a say in this matter there isn’t much you can do.
If you can choose where to pull the money from the loan there is a strategy you can use that may minimize the negative impact on your investments. If at all possible, you should consider pulling your loan from the fixed income portion of your portfolio. This is especially true in a low rate environment where your fixed income allocation may be earning just a few percent each year. The thing about this strategy is that you know exactly what your opportunity cost is if you pull money out of a fixed account.
If your fixed account is earning 2.5% currently you know that if you borrow $10,000 from that part of your portfolio you’re only giving up a 2.5% return on that money in the first year, and probably not much more in subsequent years. On a one year loan that’s like giving up $250. When you factor in the extra money you pay into your 401k while repaying the loan you’ll probably still come out ahead. Compare that to borrowing from the stock portion of your portfolio. Here, the opportunity cost cannot be determined until after the fact. What happens if you pull $10,000 out of your stock funds for the loan and the market sees a 12% gain that first year? Not that you could have predicted it, but that loan just cost you $1,200. Sure, one can argue that the market could have gone down 12% and you saved yourself from losing money, but there’s no way to predict that ahead of time. A calculated risk is better than rolling the dice.
The Dangers of Default
While it was already mentioned earlier, it is worth discussing the dangers of defaulting on your loan one more time. As long as you’re an active employee with the company that maintains your 401k you have nothing to worry about since your loan payments will be made via payroll deduction. But what happens if you quit your job or get fired? In most cases, that means you only have 60 days to pay the outstanding balance of your loan before you default. When you default, your employer then reports to the IRS that you were unable to pay the loan, and they will then treat the defaulted amount as a hardship distribution. As a distribution you’ll then be required to pay taxes on the outstanding balance plus an additional 10% if you’re under age 59.5.
Let’s think about that for a minute. Say you borrow $10,000 from your 401k and you get laid off eight months later. Maybe you’ve repaid about $2,000 of the balance so far, but that means there’s still $8,000 that needs to be paid. You’re now given just 60 days to come up with $8,000 in cash or else it will be treated as a default. If you were in a difficult financial position to begin with that required you to take the loan do you really think coming up with that cash is going to be possible?
Assuming you can’t repay the loan in full and you do default that $8,000 will then get reported to the IRS as a early distribution from your retirement plan. So, come tax time you’re going to owe regular taxes on that amount plus the 10% penalty if you’re taking the distribution early. If you’re at the 25% tax rate that means your federal tax liability will be somewhere around $2,200. Again, if you’re experiencing financial difficulties which made you take out the loan in the first place what kind of trouble might this put you in with the IRS?
Finally, don’t forget that the defaulted amount is treated as taxable income, which increases your total taxable income that determines things like tax rates and phase out limits for other tax deductions and credits. If this distribution puts you over the limit for claiming additional tax deductions or credits you’re used to it could create a massive tax liability. As you can see, defaulting on your 401k loan may have far-reaching effects.
In rare cases, some plans will give you the option to continue making your loan payments after termination via a coupon book, but even that doesn’t come without its drawbacks. Making these payments may keep you from going into default, but as long as there is a loan balance outstanding you’ll be unable to roll over your 401k to an IRA or another qualified retirement plan. This means you’re still tied to your old 401k even after termination until your loan is repaid or you default.
Other Options Before Taking a Loan
Borrowing against your 401k may be better than some alternatives, but as you can see it’s by far the best option if not done properly. And some things are completely out of your control such as losing your job after taking out the loan. We’d all like to think we’ll remain employed, but if that doesn’t happen you’re then on the hook for the remaining loan balance. So, before taking that loan there are a few things you may consider first.
Above all else, you need to create an emergency fund. If you haven’t started one already, just start small and put a little money away each week. It might not be a lot, but after you have a few hundred saved up it is going to help provide you with a little safety net that can keep you from having to resort to high-interest credit cards or taking a 401k loan for just a small and temporary emergency. I’d recommend opening a high-interest savings account online that will put your money to work, won’t burden you with fees, and keeps the money just out of arm’s reach so you don’t spend it unless you really need it.
You should also consider opening a Roth IRA at a discount broker like TradeKing. Not only is this a good idea for generating tax-free income in retirement, but these accounts also provide you a little more flexibility and let you take control of your money. One major benefit of the Roth IRA is that you are allowed to take your contributions out at any time without being taxed or paying a penalty. It still has the drawback of opportunity cost, but you have the option to take the money out of an IRA as you need it. No loan fees, no interest to repay, and you can work with your tax preparer or CPA to minimize the tax burden.
Finally, don’t underestimate the benefits of a 0% APR or low-interest credit card in a pinch. This isn’t recommended if you’re already up to your eyeballs in debt, but having a credit card on hand can still be better than taking a loan from your retirement plan. For example, say your hot water heater or other major appliance breaks and you need to spend $1,000 to get everything back to normal. You might take a 401k loan, but that will likely cost you between $50-$100 in fees plus any lost opportunity if you pull money out of an investment that increases in value. Compare that to a 0% credit card. You could put the $1,000 on there and possibly have up to a year to repay it without incurring a single fee or penny of interest. Even if you do have an interest rate of say 15%, if you schedule regular payments to have it paid off in a timely manner it may end up still costing less than taking the loan.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.
This is exactly what I needed to know. I came here from LWML and saw this topic and jumped on it! This was very informative. Thank you.
This is what I have been searching in many websites and I finally found it here. Amazing article. I am so impressed. Could never think of such a thing is possible with it...I think you have a great knowledge especially while dealings with such subjects
I have a 401k from a previous employer I now work with a different company. I have $180,000.00 in stocks and bonds and $25,000.00 in what they call cash which I'm just getting intrest.
I have a question. I was employed with a company over 30yrs. Was laid-off in January 2012. I never received a separation from service distribution form until apr 1 . I had a 401k loan. I also received a report from retirement plan early July of what i had in my account in the retirement plan. I saw that a deduction for the amount of the loan was deducted. Im 62. What i dont understand is shouldnt I have recieved the separation from service distribution form right away after being laid off. Also on the form is says My termination date was 1/9/2012 and the date of default on the outstanding loan was 1/16/2012. I thought I had 60 dates to pay off loan or roll over amount . Was this legal/ethical for my company to do this? So, am I paying more in taxes since it was done this way?
Hi Jeremy, Question: I took out a loan on my state employee retirement plan a few years back and have another 3 years of payments. However, I am now in a position where I could pay back the lump amount still owing. As I am "paying myself back" as they say, is there a benefit to repaying early or should I just keep paying the monthly payments and keep that $4k in my account for emergencies?
Good day. I am an South African working for a joint American/Indonesian company, I have a 401K retirement plan...how will I be affected by tax, do I pay american tax, Indonesian tax when it is paid out. And if I take a loan and lose my job before it is paid in full, how are they going to get there money ...tax/outstanding balance etc from me if I am not an american citizen
Before you decide to take a loan from your retirement account, you should consult with a financial planner, who will help you decide if this is the best option or if you would be better off obtaining a loan from a financial institution or other sources. The benefit of taking a loan is that the interest you repay on a qualified plan loan is repaid to your own qualified plan account instead of to a financial institution. However, make sure you compare the interest rate on the qualified plan loan to a loan from a financial institution.
I live in Canada so do we have this option to borrow from our retirement fund and if so how do we go about it.b????I am on disability now and have exhausted all monies given from ei and now just trying to line on work insurance. There is too many things to pay for.please advise wher I can get a loan . Thank you for your help
I have 8% deducted from my paycheck every month to put into my 401K. I want to pay off my credit card which has gotten out of hand. I can take a loan from my 401K to pay it off. Does the 8% I contribute from my paycheck count as the monthly payoff to the 401K loan or is that in addition to the 8% contribution. For example, My monthly contribution to my 401K is $250, the loan payback amount per month is $200. Does the $200 come out of the $250 or is there going to be a total of $550 deduction from my paycheck? I hope that made sense. Love the article by the way.
"You are also repaying part of the loan with money that has already been taxed." is not a valid disadvantage. Because the money you are getting from the loan, you can use it as if it were after-tax anyway, so there is no difference that you are paying back after-tax money.
My company was sold Jan of 2011. The new owner did not take over the 401 k and so we were told to move the money from the current provider. I rolled some money into a ira at my bank. I had a loan and the provider said it must be paid and they would only send the check minus the loan balance they were paying off the loan I wanted to continue my payments and they said I could not. Now I find out the pay off of the loan amount was taxable I cant believe this! Can you explain or is this a mistake. Please helf
I am 78 years old. I have made three withdrawals (loans)totaling $25,000 in the last 60 days plus a MWD prior to that.
I would like to replace the $25,000 but was told I could only replace a single withdrawal if it were in the last 60 days.
Some folks tell me I can replace all three and others have told me I could only replace one.
What is correct?
I have a 401k from a previous employer I now work with a different company. I have $180,000.00 in stocks and bonds and $25,000.00 in what they call cash which I'm just getting intrest. Since I am not enrolled in 401k with new job can I stillbarrow money and pay them back over 5 years.
How long does it normally take to receive the funds once a 401k loan is requested? My loan is in a committed status. What does that mean?
If a person is in retirement and has met their minimum distribution, can they take for instance:
)A distribution (Loan) of 5k the first of Nov. and a distribution of 5k the last of Nov. so long as it is all paid back within the 60 days?
(I believe it is called a "Direct Rollover").
2010 I withdrew $1000 loan from well-Fargo. Just finish paying off the loan early the monthso I requested for another loan again, they told no because I old deen loan back in 2007 the time I got lay off. If that the case why I got loan last year. I'm paying distribution weekly out of my payroll
I got laid off from a Fortune 100 company two years ago. I'm nearing the stage of exhausting all my savings (amazing I've lasted this long!).
I understand a loan from a 401K can become due within 60-90 days after losing your job, but do 401K administrators allow someone who has been laid-off to take a loan from their plan?
I thought so, until doing web research and can not find anything. I'm hesitant to call my Plan Administrator (Vanguard) to find out. Any idea if I can take a loan from my 401K if I'm jobless? Thanks.
I also wanted to ask about debt consolidation loans or companies that claim they can consolidate your crdt cards and save you money is it true they hurt your credit and is it worse or same as bankruptcy
My husband and I are thinking of taking a loan out from his work. His boss doesnt agree with this so is not really working with us to get it done. Is there a work around? We have a ton of cc debt and behind in a mortgage. Do you know if you can make double paymnts or extra paymnts on the loan? We really cant think of another way of paying off this huge debt the interest is just incredible
If I roll my 401K balance into a new 401K I am thinking of starting for my sole proprietorship Company, then can I borrow from the rollover 401K balance? Thank you.
Leave it to the government to take a bad situation, such as being out of work and desperate for money, and turn it into a great opportunity to gouge you come tax time. Is this what Rahm Emanuel meant about never letting a good crisis go to waste? Why don't we ask the obvious question-- where the hell does the US government get the right to decide how you save, borrow, or spend your retirement money? Is it even yours at all? Do you really want your retirement micromanaged by the same folks who created a multi-trillion dollar debt which will never, ever be repaid?
Thanks for the quick response, Jeremy! & on a holiday weekend, no less.
Job security is not in the back of my mind.. it's always in the front, having survived quite a few rounds of layoffs over the past few years. That's one reason I am reconsidering using my IRA- less out of the 401k would mean less due if I do get laid off. Unfortunately I haven't had the IRA for 5 years so I will need to find out what the penalty would be if I go that route- something that I had not considered. Thanks for pointing that oversight out to me.
I'm in total agreement with you on paying back the 401k as quickly as possible & am planning to do so. & yes, the forced payoff from a 401k is a positive to me. It's way to easy to let good intentions slide when life gets in the way & then I'd be down at retirement. Since I got a very late start saving for retirement I am extremely intent on ensuring that I do not foolishly squander what I have.
Thanks again for giving me more info on which to base my decision. This is a very useful site to have found!
I have a question based on the info in this article. I'm under contract to buy a house & was planning to make up the difference needed to close by taking out an 8k loan against my 401k. I've also got a small Roth IRA with approximately $2300 that I was planning to keep in tact. My reasoning is that if push comes to shove, the IRA would be more accessable with less penatiy than having to go back into my 401k.
Does that make sense or does it make more sense to use the IRA & borrow ~2k less from the 401k?
Very interesting article !
Question : What happened with the loan when the company change the 401k program provider ? Is the loan term transferable ?
In my case, according to my HR office, a loan would also prohibit me from participating in my 401K for 6 months which means no matching contributions. This would end up costing me a few hundred more dollars per month. Scratch that idea (for me anyways)
I was married to my husband only months then he suddenly died, yes I am the beneficiary on his 401K. My question is how long do I have to wait before I can receive the benefit or can I just get one lump sum.
The background for my situation is extensive and aggravating and not really pertinent. But, we need a 45K loan/withdrawal from our 401k VERY soon for all of 2-3 weeks. At the end of that time the entire amount (and any fees/interest) can be repaid. But, the statement that repayments have to be spread out over the life of the loan concerns me.
No doubt a 401(k) loan should be the last option. Thanks for giving it the attention it deserves. Too many people have no idea what they are doing when they tap into their retirement.
I've been trying to find a way to pay-off our 20% loan which is at 8.25% and due in 4yrs and can get a 401k loan to cover 60% of the remaining balance @ 4.25%. I think the rate is attractive and allows us to better cash flow.
This article really helps me understand the risks/rewards of taking the loan. As Hank pointed out the Opportunity Cost on the money borrowed is cause for pause but I think the largest thing for me would be the Opportunity Cost of having the flexibility to leave my current employer. It severely limits my ability to take a plumb job should one arise.
Thought I'd share that perspective.
My fiance is 64 and is receiving his social security retirement benefits. He withdrew most of his 401k last year. Do the proceeds from a 401k count as income towards social security?
@anymtr I am their now, the loan re-payment is separate from your contribution. If you leave you contribution the same yes, you will have 550 deducted from you paycheck, Oh and thats $250 pretax and $200 posttax
@anymtr Loan payments are in addition to any regular contributions. So if you kept your 401k contribution where it is you'd have a total $550 deduction from your paycheck. Hope that clears it up for you.
@meloweee Unfortunately, this is one of the big drawbacks of 401k loans. These loans are tied to that specific plan, and rarely do new providers assume existing loans. The same is true if you lose your job or leave a company before the loan is paid off. You generally only have a specific amount of time to repay the loan in full or else the balance gets treated as a premature distribution and would be subject to taxes and/or penalty.
It really depends on your plan provider. I've seen some plans do overnight delivery of the funds if requested. But typically it will take about 5-7 business days. You may want to call your plan if you've been waiting a while and aren't sure when the funds should arrive.
Ryan, typically when you are no longer employed, then you're no longer able to take a loan. Instead you'd just have to do a straight distribution, unfortunately. If you think you will need to tap into some of that money your best bet is probably to roll it all into an IRA first, and then dip into that as you need it.
It's just easier and there's more flexibility to work with distributions from an IRA than working with a 401k. Plus, once it's in an IRA you will still get the 60-day provision that allows you to repay what you've taken out in that time frame to avoid penalties, which is effectively like giving yourself a short-term loan. But one thing worth noting is you only get the 60-day grace period for one withdrawal per yer, so plan accordingly.
Bill, are you talking about opening a Solo 401k? If so, then yes, the same loan provisions apply as long as you establish the plan stating that loans are allowed.
MM, have you had a roth IRA for more than five years? If so, you'll at least avoid the penalties on the withdrawal and just pay taxes on the gain, if any.
Also, what about job security? If something happens and you lose your job you're on the hook for full repayment of the 401k loan or else get taxed. Nobody ever wants that to or expects it to happen but it's worth keeping in the back of your mind. So the less you borrow from the 401k would at least minimize this small risk.
But at the very least, with a 401k loan you have to repay it, so it's good that it basically forces you to replace the money you borrowed. With an IRA there is no requirement replenish the money so it's up to you to put the money back on your own.
So there probably isn't a right or wrong answer here and it's just a matter of weighing the potential risk of being on the hook for the 401k loan in the event something happens. Since it is a slim risk and you have limited other options you can probably get away with just doing what you're most comfortable with.
With the loan though, I'd opt for the shortest repayment term you can afford to further minimize the impact of being taxed twice on the interest and having money out of the market unable to work.
In most cases if a new provider takes control of the plan all of the existing loans and repayment schedule will continue as if nothing has changed. I'm sure there may be a few exceptions, but in all of the cases I've seen this was the case.
I have never seen the case as when you are taking loan you can't make contributions but yes in case of hardship withdrawals you are suspended of making any contributions (both employer and employee) and the time frame is usually 6 months..
Looks like my HR office is clueless. They quoted me policies of a hardship withdrawl. Apparently our plan does not offer 401k loans at this time but the conversation has been started.
In this case the docs needs to be sent to your admin team and then they will do the processing. They will get you enrolled and then they will pay as your desired mode (Lump sum or rollover)
Never mind. It turns out there's no early payment penalty nor is there a hardship requirement. And, as the loan will be repaid even before the first payment would be due, I feel reasonably confident that unless the stock market does something amazing, that we will lose a relatively small amount of earnings. Which in the circumstances is fine. great article which helped me understand what was happening though.
Suzie, 401(k) withdrawals do not count as earned income in a way that will affect social security eligibility, but the income may raise the total taxable income to a point where part of social security benefits are taxable.
@Jeremy Vohwinkle Thank you. I think I will think about this a little bit. I might need to lower my monthly contribution as I do not want to take home less than I already am if I decide to take a loan against my 401K
Yes, I would establish a 401K plan for my sole proprietorship with allowance for loans, roll monies from two prior employer 401Ks into the new one for my Company, and then take a short term loan out from it. Someone had cast doubt on the ability to borrow from funds rolled in from another 401K, and you seem to have cleared up that there is no borrowing restriction on rolled savings from my old 401Ks to a new one. Thank you.