The Case for 401(k) Loans

Experts always know everything but the fine points.
— Hedy Lamarr

Today I’m going to revisit the topic of 401(k) loans. As I’ve mentioned before, they are nearly universally pilloried by personal finance gurus, but they have their uses.

Suze Orman’s objections to 401(k) loans are fairly typical of what you’ll hear from the “experts.” Let’s see how they stack up to reality.

Objection 1 — A 401(k) loan is only good for as long as you stay at your current job.

Not necessarily true. In fact, it’s up to your employer and plan administrator. Some may allow you to continue making payments on an outstanding loan even after you leave.

Admittedly, this is fairly uncommon, as it winds up being a bit of an administrative hassle for your employer, who naturally doesn’t have much vested interest in helping you out once you’ve left. Still, some do allow it, so it can be worth making inquiries, especially if you are on good terms with your employer. (Delicately, of course — you don’t want to give off the impression you’ve got one foot out the door.)

That said, this is a valid concern, overall. If you do leave or get laid off, and your employer refuses to let you continue to make payments, you’ll have to pay off the balance. Otherwise, the consequences are pretty dire: the remaining balance gets treated as a distribution, and you’ll get hit with income taxes plus a 10% penalty.

Of course there are ways to mitigate this risk. You can always take out a traditional loan and pay off the balance, for example.

All in all, it’s best not to take out a 401(k) loan if you expect to change employers during its term. But there’s no need to be paranoid about it. Just have a contingency plan in place in case you end up having to leave.

Truthiness rating: Semi-Legit

Objection 2 — The money you repay will be double-taxed

It’s distressing how widespread this little gem is, given the fact that it’s complete bullshit. The theory goes that, since you have to pay the loan back with after-tax money, and you’ll eventually have to pay taxes on your 401(k) withdrawals down the line, the money gets taxed twice. Oh noes!

To see why this “reasoning” is fallacious, let’s try a little thought experiment. Let’s say you take out a $10,000 401(k) loan. You stroke your little stack of bills lovingly for 30 seconds, then immediately pay it all back. How much money gets double-taxed? The answer: not a cent. Why? Because receiving the loan proceeds was not a taxable event.

And that’s the trouble with Suze’s theory — it doesn’t account for the fact that you received the loan proceeds in the first place. If you want to get it straight in your head, visualize that same $10,000 you received tax-free when you took out the loan going back into your 401(k) bit-by-bit over time.

What can technically get double taxed is the interest you pay to yourself. But this is a much, much smaller amount, and hardly worth Suze’s histrionics. It might even end up earning a better return in the end, despite the double taxation, because of the tax deferral — depending on how far you are from retirement, and your investment style.

Even this is only true for a traditional 401(k). If you take your loan from a Roth 401(k), not even the interest gets double-taxed.

Truthiness Rating: 96% Horse Hockey

Objection 3 — You might miss out on a big bull run in the market

This is just silly. Sure, you might miss out on a big bull run. Then again, you might also miss out on a big crash. Do you know which it will be?

Take a step back for a moment and look at this purely from the perspective of your 401(k) account. Remember, you pay the interest on a 401(k) loan to yourself, and the current rate is in the neighborhood of 4.25%. As far as your 401(k) is concerned, then, the loan is exactly the same as a fixed income investment. It’s basically a short-term bond that pays 4.25%, which is a much, much better rate than you can get with treasuries these days.

Most of the same financial gurus who disparage 401(k) loans will tell you to keep some part of your retirement in bonds. Just consider your loan to be part of the bond portion of your overall portfolio, and rebalance the remainder of your account to be heavier on stocks to account for the difference. In the most extreme case, if you borrow half of your account (which is the maximum), you can put 100% of the remainder in stocks, for a 50/50 ratio of stocks to fixed income. This may be a more conservative mix than you’d otherwise choose, but it’s hardly an unreasonable asset allocation.

Truthiness rating: 99% Horse Hockey

Overall, while there is some truth to the warnings you’ll hear about 401(k) loans, they’re vastly overblown. A 401(k) loan is a tool, and as I’ve said many times, any tool that can be used can be abused. The consequences can indeed be severe if you are careless or don’t do your homework. If you’re smart about it, though, a 401(k) loan can work out just fine 1.

  1. Stay tuned for a case study in a later post.

3 Comments

  1. Wow you guys can take loans out of your 401(k)’s?? That’s a fair bit different to here in Australia. Our Super accounts have a forced 9% employer contribution scheme and on top of that, you can’t touch the money until you’re 60!

    I can see how many people would certainly abuse the option for a 401k loan though… very tempting if you’re down on your luck (or you REALLY want that new Mac Book Air :-P).

  2. Sean Owen

    Oh it’s much worse than that – in the U.S. you can cash the account out pretty much any time you want. You just have to pay taxes plus a 10% penalty. People do it all the time.

    The Australian system is vastly superior. You have no choice but to participate, and can’t get at the money early. We really should adopt that model here, but it’s politically unfeasible.

    I didn’t mean to imply that taking out one of these loans is an awesome idea for everyone, by the way. Just like credit cards, they’re terrible for most people, but can be put to great use with the proper thought and discipline.

  3. Our system does have it’s flaws too, you have companies taking advantage of people not caring and charging massive fees. You have the fact that if I want to retire early (not 60+!) I can’t access the funds and instead have to “save for retirement” in a full taxable account etc.

    Still… It does seem somewhat better 🙂

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