Should I Take a 401k Loan? (And Other 401k Loan Questions)

Many 401k plans offer a loan feature. Typically 401k loans are limited to the lesser of 50% of the participant’s vested plan balance or $50,000 and are repaid over five years via payroll deduction (or in a lump sum upon separation from the employer).1 One reason plan sponsors offer a 401k loan feature is that the feature encourages employee participation. Employees are more prone to contribute to 401k’s if they know that they can access the funds, especially in an emergency.

Source: Vanguard; Boston U Center for Retirement Research

Source: Vanguard; Boston U Center for Retirement Research

If you participate in a 401k that has a loan feature you’ve likely considered at some point whether a 401k loan could make sense for you.

Most financial advisors warn against 401k loans on the grounds that retirement assets should never be used for current consumption. Also, there is real danger with 401k loans that if an unforeseen event (e.g. loss of job) causes a loan repayment default, you could significantly reduce retirement wealth and increase your tax liability.

Still, there is academic research that shows, from a pure economic standpoint, a properly handled 401k loan can be the least costly form of borrowing available. Used prudently (e.g. to replace high interest credit card debt), a 401k loan could even help improve a household’s overall financial picture and free-up dollars to use to increase household 401k contribution levels.

The table below shows the characteristics of 401k loans together with a summary of the key arguments for and against these loans.

401k Loans – Characteristics, Pros and Cons
401k Loan Statistics (2004)2
  • 46% of Households Have 401k Plan
  • 32% of Households Can Take a 401k Loan
  • 16% of Households That Can Take a 401k Loan Have a 401k Loan
  • 2004 401k Loan Eligible Households: Age (41.5), Median Income ($62,600), Median 401k Balance ($20,700)
  • 2004 Median 401k Loans: Loan Balance ($4,000); Months to Payoff (23)
  • 2004 401k Loan Purposes: Home Purchase/Improvement (25%), Investment or Debt Consolidation (36%), Vehicle and Other (39%)
  • Key Points in Favor of 401k Loans
  • Low transaction costs
  • No credit check
  • Convenient – typically requires simple phone call or brief on-line application to access funds
  • Possible tool to maximize contributions – if the 401k loan carries an interest rate higher than the expected 401(k)return over the repayment period, the loan can actually increase the amount of tax-favored saving.3
  • Last resort – as a source of “last resort” emergency funding, a 401k loan is a better alternative than a hardship withdrawal since you can avoid early withdrawal penalties and income taxes.
  • Key Points Against 401k Loans
  • Unknown opportunity cost – you forgo earnings and appreciation that would otherwise accrue if the funds remained in your 401k. In a bull market, these costs could be substantial. Unlike a loan from the bank with a fixed interest rate, the actual cost of a 401k loan can’t be known until after it is fully repaid.
  • Too convenient – for many, 401k loans disrupt retirement savings mentality and behavior by making it too easy to access funds
  • Separation from job – if you lose or wish to switch jobs, the full outstanding amount of the loan may be due and payable within a short period (90 days)
  • Repayment default – if you somehow default on repayment of a 401k loan, the full amount outstanding becomes a premature taxable distribution with a stiff 10% early distribution penalty.
  • Tax consequences – if you counted on pre-tax 401k contributions put you in a lower tax bracket, be aware that loan payments won’t have the same effect. 401k loan repayments are after-tax and have no tax benefit.
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    The academic argument favoring 401k loans as a means to increase houshold wealth is notable and useful, particularly for individuals who are savvy and disciplined in personal finance matters. For the majority of 401k participants, though, the standard rule of thumb (use 401k loans only as a last resort) remains sound advice.

    To learn more about 401k loans, refer to these other FAQ pages as well:

    1. Will I Pay Taxes Twice on a 401k Loan?

    Notes:
    1. Loans for the purchase of a principal residence may generally be repaid over a longer period – e.g., 15 years. From 2005 to 2007, the loan limits were increased to the lesser of 100% of the vested plan balance or $100,000 for qualified borrowers affected by Hurricanes Katrina, Rita, or Wilma. []
    2. Borrowing From Yourself: 401(k) Loans and Household Balance Sheets []
    3. Borrowing From Yourself: 401(k) Loans and Household Balance Sheets pages 5-6 []