We’re in the midst of tough economic times and a lot of people are finding themselves in situations where they need to come up with money quickly in order to pay for one debt or another. Whether it’s IRS tax debt or needing to replace a broken water heater, there are times when people find themselves with a large bill with no emergency fund to pay it. So what do you do in a situation like that? For many people the answer is to take out a 401(k) loan. Up to 3/4 of company 401(k) plans have a provision available to do a 401(k) loan, and up to 30% of people with one of those plans have taken advantage of that and taken out a 401(k) loan.
Taking out a 401(k) loan can be a legitimate road to take if you’re dealing with a serious financial situation like IRS debt or a foreclosure. You should also be aware, however, that there are risks to taking out a 401(k) loan.
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How 401(k) Loans Work
Before we get too far into talking about the pros and cons of the 401(k) loan, let’s look at how they typically work. Different plans may have different rules and regulations surrounding 401(k) loans, but typically they’re pretty similar.
- Minimum withdrawals: Most plans will have a minimum amount that you can take out when doing a 401(k) loan, typically anywhere from $500-1000. They do that in part to try and discourage people from taking out small amounts from time to time to pay for smaller bills, to discourage people from short-circuiting their investment gains.
- Maximum loan amounts: Typically you’re allowed to borrow up to 50% of your vested balance in your 401(k) account, but no more than $50,000. Also keep in mind that quite often you won’t be able to borrow from your vested company matching funds, but only personally deposited and vested funds.
- Payment terms: Usually 401(k) loans have a 5 year payment term, and the interest rates are usually set at prime rate plus 1%. If you’re taking out the loan to buy a home, longer terms may be available.
- Fees to process your loan: Many plans will charge a fee just to process your loan – a fee anywhere from $50-100.
When taking out a 401(k) loan be sure to know what the provisions and stipulations of doing one are with your company’s 401(k). Depending on what the fees are, maximum or minimums may be, you may not want to go down that road.
Pros Of Doing A 401(k) Loan
I’m not a huge proponent of doing a 401(k) loan just because I think it short-circuits the gains you could see in your retirement account, and it carries some significant risks. That being said, there are some situations where I might consider doing one.
For example, if you’re in a situation where you’ve got a large IRS debt that you need to pay, I think a 401(k) loan might be preferable to getting in trouble with the IRS. You don’t want to go to prison. Or if you’re in danger of going into foreclosure, or losing a vehicle to repossession, you may want to consider it. Just know the risks.
Here are some reasons why a 401(k) loan can be a good thing.
- Very little paperwork needed: Typically a 401(k) loan requires very little paperwork and can be done regardless of if you have an actual need. In many cases it’s as easy as making a phone call or clicking a few links in your online account. The only time you may need additional paperwork is if you’re using it for a home loan.
- Paying yourself interest: When you get a loan from your bank or a credit card you’re going to be paying interest to them on the loan proceeds. With a 401(k) loan you’re paying yourself interest. Sounds like a good deal right?
- Easy repayment: Quite often a 401k loan repayment comes directly out of your paycheck. That makes paying your loan back easy – it comes directly out of your paycheck so you never see the money and feel the pinch of losing it.
While I don’t typically suggest a 401(k) loan, it can be an option if you’re in a pinch and you have to pay off a pressing debt right away. There are some positives of doing one, but you also have to be aware of the significant risks – which we’ll look at next.
Cons Of Doing A 401(k) Loan
There are some considerable risks to be aware of when doing a 401(k) loan. If you’re not careful they could come back to haunt you.
- Fees, fees, fees: If you’re not careful you could be losing quite a bit of money to fees. There can be loan origination fees, and in some cases annual maintenance fee. So for example, if you take out a $1000 loan, and then have a $75 origination fee and $25 maintenance fee on a 5 year loan, you would end up paying $200in fees – or 20%. That’s a steep price to pay. Be careful to know what fees your plan charges.
- Defaults, penalties and taxes: If you go into default on your loan for one reason or another it will mean that the money will be taxed at your normal rate, and you’ll be charged a 10% early withdrawal penalty. That could mean a huge tax payment when it comes to tax time, something most folks may not be prepared for, especially if the money is already spent.
- Money taxed twice: When you repay your 401(k) loan, you’re using post-tax money to repay it. But since the money is then going back into a pre-tax account, it will then be taxed again when a distribution is taken in retirement. Double taxation!
- Moving jobs or being fired means loan comes due: If you end up deciding to move to a new job, or if you get let go from your current job, the 401(k) loan will automatically come due in full – although usually there is a grace period of 60-90 days. If you can’t pay in that time you’ll be subject to a 10% penalty and your normal tax rate just like a normal default. That can mean upwards of 35-40% in taxes and penalties. So when tax time comes, you may have a big tax bill at a time when you can least afford it!
- Lost retirement gains: When you take money out of your 401(k) you’re taking away from any gains that your retirement funds may have made during the interim. The cost can be especially great if you take the money out at the bottom of the market and it isn’t returned to the account until later when the market is higher. You lose out on any gains your money may have made.
So as you can see there are a ton of cons associated with taking out a 401(k) loan. There are risks associated with the fees charged, penalties if you default or lose your job and can’t pay in full, and the lost opportunity cost of not realizing investment gains. Those are some pretty serious things to consider.
Try Considering Other Options First
My suggestion when it comes to taking out a 401(k) loan is to avoid it if you can and try other options first. What are some other options?
Try saving up an emergency fund in advance so that when you have a need for a large chunk of cash you’ve already got it saved and ready to go. That’s what I’ve done with our 12 month emergency fund – so that when big bills come due, like my recent $5000 tax bill, it wasn’t a problem because we’d planned ahead.
Another option is to open and use a Roth IRA account for your retirement savings instead. When you use a Roth, you can withdraw your Roth IRA contributions at any time without any tax penalties, so you can avoid those risks of the 401(k) loan. You’ll still be having the risk of losing out on investment gains, but at least you won’t be paying taxes or penalties.
If and when you decide to go down the road of a 401(k) loan, however, make sure that you’re doing your homework. Go run the numbers using a 401(k) loan calculator and see just what interest rates you’re actually paying. That may help you to decide if it’s actually a good deal.
Have you ever taken out a 401(k) loan? If so, how did it turn out, did you pay it all back, or did you face paying taxes and penalties? Tell us your 401k loan experience in the comments.
One uncommon positive use of a 401k loan is to create an additional investment strategy to the options inside your current 401k. Instead of consuming it, it simply goes your own brokerage account using a better strategy.
The lost cash flow from your paycheck is repaid to yourself directly from the new brokerage account and the interest you repay the 401k loan is a part of your regular ongoing contributions to the account that you’d be making anyway.
Nope and hopefully I’ll never have too.
Double taxation, yikes! Good writeup, I’ve heard about these loans and now I know to stay away!
Peter,
Sadly, you are wrong.
You make the same mistake nearly every other article makes about 401(k) loans. You assert double taxation on the money that is used to repay the loan. This is simply not true. Yes, you do pay the loan back with after tax dollars. However, the money that is distributed in the form of the loan is provided without tax being levied.
So, let’s try this scenario. Let’s say “Phil” borrows $5,000 from his 401(k) account and deposits it into his bank. He has borrowed the money and currently does not have a tax liability on those dollars. Let’s say that Phil was going to use the money for a down payment on a piece of property but the deal fell through. So, Phil now has a $5,000 dollar loan and he also has $5,000 in the bank. Let’s also assume that Phil’s plan allows him to repay his loan in advance. So, he does. He takes that money from the bank and repays the loan in full (including any fees and interest owed).
He has repaid his loan and there is no tax liability until he makes a permanent withdrawal at a later date.
Let’s now assume that Phil actually made the real estate deal. He used pre-tax dollars to conduct a purchase that does not afford such a tax benefit. So, to replace those dollars he must pay the loan back with after tax dollars. So, from a tax standpoint there is no difference and there is no double taxation.
But, let’s take the opposite view. If Phil were to be able to pay his loan back on a pre-tax basis, he would have a double pre-tax benefit and the best advice to everyone would be to borrow as much as possible as often as possible.
Imagine the tax benefit of borrowing and repaying with a pre-tax deduction. That would be a great way to amp up your earnings on your 401(k)! In essence you are getting a tax deduction when you make your contributions from your paycheck. If you could borrow and put the money back again on a pre-tax basis, you would be able to multiply your tax deduction on the same dollars over and over again.
So, no, loans do not result in double taxation on the dollars borrowed and repaid. However, you do pay double tax on the interest portion – but not the principal amount of the loan.