The Pros and Cons of 401(k) Loans

Are you in need of some financial flexibility? A 401(k) loan might be a viable option. However, it’s crucial to understand the potential benefits and drawbacks.

The Basics of 401(k) Loans

If your 401(k) plan allows it, you may be able to borrow a portion of your account balance. Typically, the maximum loan amount is the lesser of 50% of your account balance or $50,000 . For example, if you have a balance of $60,000 in your 401(k) account, then the maximum that you can take as a loan is $30,000. You are also commonly limited to having one loan at a time.

401(k) loans normally don’t require a credit check, they process quickly, and typically have lower interest rates than other forms of credit.

Repayment schedules are often limited to 5 years but could be extended if the loan is being used for a primary residence.

Important Considerations

While 401(k) loans can be convenient, there are several factors to keep in mind:

• Interest: Like all other loans, 401(k) loans carry interest. However, the interest payments that you make are being paid to yourself. While this might seem beneficial at face value, it also means that your retirement savings might not grow as quickly because your monthly savings will be impacted by paying off your loan in the first place.
• Investment Growth: While you’re paying back the loan, the loan amount itself won’t be invested. This means you’ll miss out on potential investment gains on up to half of your 401k (assuming you take the largest loan possible).
• Early Withdrawal Penalties: If you leave your job or fail to repay the loan within the specified timeframe, the outstanding loan is officially considered a distribution. There are meaningful tax implications to taking distributions from retirement accounts, and you may be subject to early withdrawal penalties.
• Double Taxation: A less-known aspect of 401(k) loans is the potential for double taxation. Since you’re paying back loan interest with after-tax dollars, you could theoretically be taxed twice on the same money: once on the money you earned that paid the loan interest and the second time when the funds are withdrawn in retirement.

Mitigating Double Taxation with Roth 401(k) Loans

One way to potentially avoid double taxation is to take a loan from the Roth 401(k) portion of your account. Roth contributions are made with after-tax dollars, and the earnings grow tax-free. If you take a loan from your Roth 401(k) and pay the interest back to the same account, you’re only paying tax one time with the earned income used to make interest payments. However, it’s important to check with your 401(k) plan administrator to ensure that your plan allows for this type of loan structure.

When Does a 401(k) Loan Make Sense?

A 401(k) loan might be a reasonable option if:

• You’re facing a financial emergency that you can’t address through other means.
• You’re in need of a large down payment to make a home purchase.
• You don’t want to go through underwriting or a credit check for a traditional loan and are confident in your ability to repay the loan on time.
• You understand the potential risks and drawbacks, including the implications of loan interest payments, deemed distributions for failure to repay the loan, and the potential for double taxation.

Conclusion

While it can be a helpful tool in certain situations, it’s important to consider the long-term implications for your retirement savings. If you’re considering a loan, consult with your 401(k) plan administrator to understand the specific terms and conditions, and make an informed decision that is right for you.

The information provided herein is for educational purposes only, and should not be construed as advice, including, but not limited to tax, legal, insurance, investment, or retirement advice. For your specific planning needs, please seek the advice of Integris Wealth Management, your tax accountant, attorney, insurance agent, or other professional as appropriate. Investing involves the risk of loss.