A feature of many 401(k) plans is the ability to borrow from yourself. In other words, you can borrow money that you contributed to your plan, within certain limits, and pay yourself back.
Technically, 401(k) loans are not true loans, because they do not involve either a lender or an evaluation of your credit history. They are more accurately described as the ability to access a portion of your own retirement plan money—usually up to $50,000 or 50% of the assets, whichever is less—on a tax-free basis. You then must repay the money you have accessed under rules designed to restore your 401(k) plan to approximately its original state as if the transaction had not occurred.
Another confusing concept in these transactions is the term interest. Any interest charged on the outstanding loan balance is repaid by the participant into the participant's own 401(k) account, so technically, this also is a transfer from one of your pockets to another, not a borrowing expense or loss. As such, the cost of a 401(k) loan on your retirement savings progress can be minimal, neutral, or even positive. But in most cases, it will be less than the cost of paying real interest on a bank or consumer loan.
Top 4 Reasons to Borrow from Your 401(k)
The top four reasons to look to your 401(k) for serious short-term cash needs are:
Speed and Convenience
In most 401(k) plans, requesting a loan is quick and easy, requiring no lengthy applications or credit checks. Normally, it does not generate an inquiry against your credit or affect your credit score.
Many 401(k)s allow loan requests to be made with a few clicks on a website, and you can have funds in your hand in a few days, with total privacy. One innovation now being adopted by some plans is a debit card, through which multiple loans can be made instantly in small amounts.
Although regulations specify a five-year amortizing repayment schedule, for most 401(k) loans, you can repay the plan loan faster with no prepayment penalty. Most plans allow loan repayment to be made conveniently through payroll deductions—using after-tax dollars, though, not the pre-tax ones funding your plan. Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement.
There is no cost (other than perhaps a modest loan origination or administration fee) to tap your own 401(k) money for short-term liquidity needs. Here's how it usually works:
You specify the investment account(s) from which you want to borrow money, and those investments are liquidated for the duration of the loan. Therefore, you lose any positive earnings that would have been produced by those investments for a short period. And if the market is down, you are selling these investments more cheaply than at other times. The upside is that you also avoid any further investment losses on this money.
The cost advantage of a 401(k) loan is the equivalent of the interest rate charged on a comparable consumer loan minus any lost investment earnings on the principal you borrowed.
Let's say you could take out a bank personal loan or take a cash advance from a credit card at an 8% interest rate. Your 401(k) portfolio is generating a 5% return. Your cost advantage for borrowing from the 401(k) plan would be 3% (8 – 5 = 3).
Whenever you can estimate that the cost advantage will be positive, a plan loan can be attractive. Keep in mind that this calculation ignores any tax impact, which can increase the plan loan's advantage because consumer loan interest is repaid with after-tax dollars.
Retirement Savings Can Benefit
As you make loan repayments to your 401(k) account, they usually are allocated back into your portfolio's investments. You will repay the account a bit more than you borrowed from it, and the difference is called "interest." The loan produces no (that is to say, neutral) impact on your retirement if any lost investment earnings match the "interest" paid in—i.e., earnings opportunities are offset dollar-for-dollar by interest payments. If the interest paid exceeds any lost investment earnings, taking a 401(k) loan can actually increase your retirement savings progress.
How Much Can I Borrow?
In general, Department of Labor rules won't let you borrow more than 50% of your vested 401(k) account balance, but there are exceptions (see below). There are also certain tax rules that limit the amount you may take as a loan without it being considered a taxable distribution.
Under current tax law, a 401(k) plan can permit you to borrow as much as $50,000 or half of your vested account balance in the 401(k) plan, whichever is less. If your vested 401(k) plan account balance is less than $10,000, you can borrow up to your vested account balance. If your vested account balance is at least $10,000, you can borrow up to $10,000 even if 50% of your vested account balance is less than $10,000. The $50,000 amount is reduced by the highest balance of any loan you had in the previous 12 months, even if you've paid it off. For example, assume your vested account balance is $100,000 and in June of the current year you had a loan balance of $10,000 you paid off. In April of the following year you could not borrow more than $40,000.
However, a specific employer's 401(k) plan does not have to permit loans this large. Also, many plans have a minimum amount you can borrow, usually $500 or more.
401(k) plans are required to charge interest on a loan at the going rate for interest on similar loans in the community. A general rule is that the Internal Revenue Service generally considers prime plus 2% as a reasonable interest rate for participant loans.
If you don't make the payments on your loan in a timely manner or if you leave your employer without having paid off the loan, or without making arrangements to repay the loan (if permitted), the IRS will treat the loan balance as though you took a withdrawal from the plan. Consequently, you will owe income taxes on the loan balance in the year you fail to pay the loan and you may also face the 10% early withdrawal penalty. So, it's important that, if you take a loan, you keep up with the payments. And before you leave a job, pay off your 401(k) plan loan first, or, if the employer's plan permits it, arrange to make payments after you leave.
Determine the True Cost of Borrowing
What does it really cost you when you borrow from your 401(k) plan?
When you borrow from your 401(k) account, you no longer earn investment returns on the amount you borrow from the account. In effect, that money is no longer in the 401(k) plan earning money. So, although the interest you pay on the loan goes back into your 401(k) account, the true cost of the loan is the interest you are paying plus the amount you would have earned on that money had you not borrowed it from the account. You're missing out on the investment earnings on the funds that were borrowed. It's called 'opportunity cost' and it's a tricky concept. On the flipside, borrowing from your 401(k) plan can work to your advantage if the market is losing money. By pulling the money out as a loan, you're not participating in a losing market. Not participating in your 401(k) investments can work to your advantage or disadvantage, depending on the investment performance over the term of your 401(k) loan.