401(k) Loan Guide—Creativity vs. Convention

Standing on the doorstep of your dream home, you’re ready to move in, but you need cash to cover the final details. What do you do if you don’t want surprise expenses at the end of the project holding up your family? A 401(k) loan might be your solution.

Whether this scenario resonates with you or with someone you care about, it may also raise a cautionary flag. These loans may jeopardize retirement goals, lead to hasty budgeting decisions, and contribute to an unhealthy reliance on debt. However, just as a skilled craftsman uses the right tool for the right job, there are situations where a 401(k) loan can be a powerful cash resource and the best option to manage your finances effectively.

Let’s explore the concerns surrounding a loan from your 401(k) and how it can sometimes be beneficial as a short-term solution.

Navigating the Pros and Cons: Why Caution Is Advised

1. Impact on Retirement Savings: Money invested in your 401(k) will grow over time as markets climb. However, the money you take out of your 401(k) will not have the opportunity to grow until you pay it back. Your plan may allow for borrowing up to 50% of your vested balance or a maximum of $50,000. Borrowing from your 401(k) and giving up potential growth could slow your retirement progress until your loan is repaid. While you only pay loan interest to yourself, the opportunity cost can be substantial.
2. Repayment Costs: Repaying your 401(k) loan involves using after-tax funds, even though your initial contributions were pre-tax. For instance, if you borrow $25,000, you’ll need to earn around $32,900 before taxes to repay that amount after a 24% marginal federal tax rate. Any interest you accrue only widens the gap, so repaying your loan will cost you more than the original loan amount.
3. Repayment Challenges: You’re generally allowed to repay 401(k) loans within five years. However, if you change jobs or lose employment, your outstanding loan balance quickly becomes due. Failing to repay within a specified window after separating (generally the due date of your next federal tax return) will cause the outstanding amount to be treated as a withdrawal, incurring taxes and potential penalties.
4. Early Withdrawal Penalties: If an unpaid loan is treated as a distribution and you are younger than age 59½, you will typically incur a 10% early withdrawal penalty in addition to income tax on the withdrawn amount.

It’s clear that 401(k) loans carry significant disadvantages and should be considered a final safety margin rather than a first line of defense. Nevertheless, managing a loan strategically and paying it back within a short timeframe can be a valuable tool in your arsenal.

A Thoughtful Approach: When 401(k) Loans Align with Your Goals

1. Meeting Short-Term Cash Needs: Picture making a down payment, supporting a loved one’s education, or finishing a renovation where a temporary shortfall requires immediate funding. While an emergency fund or pre-planned savings are optimal, life can throw curveballs. A 401(k) loan could be your lifeline when used responsibly for short-term solutions with a 12- to 18-month payoff horizon. Paying off the loan quickly avoids hindering your retirement savings and minimizes your risk of default should you lose employment suddenly.
2. Minimizing Tax Impact: When major expenses loom, 401(k) loans can also help minimize taxes. If you have highly appreciated equity positions outside your retirement plan, a loan might be better than realizing a significant capital gain net of taxes. Timing a loan to align with anticipated cash flows like bonus payouts, equity vests, or other liquidity events may be practical to avoid capital gains tax in the meantime. A 401(k) loan could also be an effective way to delay selling equities at a short-term gain and benefit from lower long-term capital gain tax rates later. These nuanced scenarios require a case-by-case analysis of the tradeoffs.
3. Managing High-Interest Debt: For people grappling with high-interest debt, such as credit card balances or personal loans, a 401(k) loan could be an efficient alternative. However, successful financial recovery hinges on a well-defined repayment strategy and disciplined cash flow management to get back on track. Avoid using a 401(k) loan as a stopgap for continued reliance on consumer debt.
4. Executing a Thoughtful Plan: A 401(k) loan may work well if you borrow wisely and repay promptly. Creating a repayment plan with a reasonable payoff timeline that aligns with the rest of your financial goals and budget is key to success. Evaluating your career goals and avoiding borrowing when you anticipate employment changes is essential.

Charting Your Course: Consult with an Expert

While the timeless advice to avoid borrowing against your retirement savings holds true, the one word that resonates here is “plan.” With a thoughtfully devised financial plan, responsible utilization of 401(k) loans can emerge as a creative solution tailored to your unique circumstances. Your financial planner empowers you to navigate these intricacies and make informed decisions that support your financial journey. Connect with us to find out whether a 401(k) loan might unlock your next step or whether another option might prove better. Together, we can explore the balance between strategic borrowing and your long-term aspirations. Your financial journey is unique, and your strategies should be, too.

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source.  Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be taken as such. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.