When I was studying for my CFP® certification several years ago, most of my instructors discouraged borrowing from your 401k. Yet about a quarter of people who own one of these accounts dip into their funds at some point in their life. Some of these plan holders withdraw money permanently under hardship provisions that are imbedded in the rules for withdrawal. But over three times as many people borrow temporarily from their 401k’s or from a comparable account, such as a 403b or a 457.1
The reasons for borrowing are as varied as the reasons for spending; a house down payment, a child’s wedding, college costs, or just making ends meet on a temporary basis. As far as the last reason is concerned—accessing funds for use in an emergency—we presume that borrowers have already spent any funds set aside for this purpose. After all, a basic tenet of financial planning is to set aside enough savings—which some advisors equate to about six months of living expenses—for use in an emergency.
Before we discuss the pros and cons of borrowing from a 401k, we should first review the rules.
Rules for borrowing from your 401k
Although loans from 401k plans are permitted by law, employers are not required to provide this option. Many small businesses simply cannot afford the high cost of adding this feature to their plans. Nevertheless, loans are a common feature of most 401k plans. You should check with your 401(k) plan administrator or investment company to find out if your plan allows you to borrow against your account balance.
Assuming loans from your 401k are allowed, you need not have a particular reason for the loan. Loans may be provided for any reason, including a family vacation or a new set of golf clubs.
Your 401(k) loan limits are set by law. The maximum amount you can borrow is traditionally the lesser of $50,000 or 50% of your vested account balance, whichever is less. The CARES ACT temporarily extended the amount you may borrow to $100,000 or 100% of your vested balance through September 22, 2020. Your vested account balance is the amount that belongs to you. If your company matches some of your contributions, you may have to stay with your employer for a set amount of time before the employer contributions belong to you. Your 401(k) plan may also require a minimum loan amount.2
The loan must be paid back. After all, it is a loan and not a withdrawal. You must pay back your loan within five years. You can do so via automatic payroll deductions, the same way you fund your 401k in the first place. There is no penalty for paying off the loan sooner than that.
You must pay interest on the loan at a rate specified by your 401k fund administrator. This is often one or two percentage points above the prime interest rate.3 As of this writing, the prime interest rate is 3.25%.4 Thus, you should expect to pay one or two percentage points more than this amount. The good news is that since this is your 401k plan, the interest is paid to yourself.
Some Reasons Not To Borrow From Your 401k Plan
- You may not repay the loan within the designated timeframe.
Advisors warn against having a high confidence that you may repay the loan timely—that is, within five years of taking out the funds. According to one financial advisor, “People think that they will make up a withdrawal later, but it pretty much never happens."5
- A job loss or departure resets the repayment clock.
If you quit or lose your job, the 5-year repayment schedule is out the window. You may have only until the due date of your next federal tax return (usually April 15) to repay the loan, provided it’s at least 60 days after your departure from the job. Failure to repay within this window may result in a taxable distribution and possibly a penalty depending upon your age.
- You may contribute less to your 401k while you have the loan.
If you borrow money from your 401(k), some plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't stipulate this, you may be unable to afford to make contributions while you're repaying the loan.
- There may be an opportunity cost.
Funds that you borrow from your account will not be earning any investment return. These probable missed earnings must be weighed against any break you're getting for lending yourself money at a low-interest rate.
- There may loss of creditor protection.
In most cases, 401(k) funds qualify for creditor protection under a federal law known as ERISA. Under that law, plan funds, including 401(k) funds, are given an unlimited exemption in bankruptcy proceedings. Once removed from the plan, funds may lose this creditor protection.6
Some Reasons To Borrow From Your 401k Plan
Although there are many reasons to refrain from borrowing from your 401k, there may be situations in which it makes sense. When you need cash for a serious short-term liquidity need, a loan from your 401(k) plan may be a good place to look. According to one advisor, “borrowing from your 401(k) can be financially smarter than taking out a cripplingly high-interest title loan, pawn, or payday loan—or even a more reasonable personal loan.”7 Before you borrow, you should compare interest rates for alternative loan sources, including the possibility of a tapping a home equity line of credit (HELOC). Some of the potential advantages of borrowing from your 401k rather than alternative sources are listed below.
(1) Cost advantage
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. You specify the investment account(s) from which you want to borrow money, and those investments are liquidated for the duration of the loan. Bear in mind, however, the opportunity cost mentioned above. You lose any positive earnings that would have been produced by those investments for the period of the loan.
(2) 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.8
(3) Repayment flexibility
Generally, the law requires that you must repay a plan loan within five years and must make payments at least quarterly.9 For most 401(k) loans, you can repay the plan loan faster with no prepayment penalty.
(4) Retirement savings may benefit
You repay the loan balance with interest, so that you 401k account is paid back with more money than you borrowed.
In this discussion regarding potential advantages of borrowing from your 401k, we have emphasized that the loan should be short-term. If you intend to take the full five years to pay back the loan, the opportunity cost may become significant.
The decision to borrow from your 401k should not be made casually, and we suggest reviewing your situation with your financial advisor before taking out a loan. If you are considering a loan from your 401k account, or if you would like to have more information about this topic, please feel free to contact us. Remember, we are here to help.
Doug Lemons, CFP®
CRN-4990540-100822
1https://www.investopedia.com/articles/retirement/06/eightreasons401k.asp
2https://www.thebalance.com/facts-about-401k-loans-2388811
3Ibid
4https://ycharts.com/indicators/us_bank_prime_loan_rate
5https://www.investopedia.com/articles/retirement/06/eightreasons401k.asp
6https://www.investopedia.com/ask/answers/090915/can-my-401k-be-seized-or-garnished.asp#:~:text=The%20general%20answer%20is%20no,ERISA%20are%20protected%20from%20creditors. Solo 401k’s may not enjoy the same creditor protection as ERISA compliant 401k’s.
7https://www.investopedia.com/articles/retirement/08/borrow-from-401k-loan.asp
8Ibid
9https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans#:~:text=Generally%2C%20the%20employee%20must%20repay,make%20payments%20at%20least%20quarterly. The law provides an exception to the 5-year requirement if the employee uses the loan to purchase a primary residence.