When You Should Absolutely Take a Loan From Your 401K

Personal Sucess Story

I once used my 401K to pay off debt. Due to various reasons, I had accumulated $50,000 in credit card debt.

Most of it was in 0% interest promotional credit card balances.

However, my credit score was negatively impacted due to my high ratio of debt to available credit, and the promotional periods were nearing their end.

At that point, my interest rate would have risen to 22%. Instead of paying that high interest rate, I took a loan from my 401K and planned to pay off this balance over the next 5 years.

By using the 401K loan to pay off my balances, I increased my net worth and saved myself… Get this!.

$69,252.00.

As we navigate through life, financial flexibility and control become increasingly essential. Financial flexibility allows us to adapt to changes, meet unexpected expenses, and seize opportunities as they arise.

On the other hand, financial control is all about understanding and managing our income, expenses, investments, and debts effectively. Both play a crucial role in achieving financial independence and securing a more prosperous future.

In this newsletter, we delve into the concept of taking a loan from your 401K, a topic that directly relates to financial control and flexibility.

This is what I call the BYOB method or Be Your Own Bank Method. Taking a loan from your 401K and paying yourself interest can be a smart financial move if you plan it correctly. Let’s get into it.

The 401(k) Lending Basics

Borrowing from a 401(k) is a process where you take loan from your 401(k), a retirement savings account.

This is a loan not a distribution, which you are required to pay back with interest over a predetermined period of time and a maximum of five years.

If properly managed, this can provide a low-interest loan option where you become the bank.

The Benefits of Being Your Own Bank

Being your own bank is a concept that involves taking control of your finances by utilizing your assets, such as your 401(k), as a source of funds instead of relying on external lenders.

This can have several advantages. One significant advantage is the potential to avoid high-interest debt that comes with loans or credit cards.

When borrowing from your 401(k), you pay interest to yourself, not a bank, which can make it a lower-cost option if managed correctly. However, it's important to consider the pros and cons before you dive in.

Pros and Cons of 401(k) Loans

Pros:

• It can provide a quick source of cash.
• You can borrow up to 50% of your 401K value up to $50K.
• The interest rate is typically lower than that of other loans.
• The interest you pay goes back into your account. (You become the bank).
• Fees for managing the loan are typically very reasonable. Last time I did this, it was $100/year.
• There’s no application or no credit check required. Therefore, it doesn’t affect your credit.
• And the payments are withdrawn from your paycheck every pay period automating the payback.

Cons:

• You could face hefty tax penalties if the loan is not repaid in time.
• If you leave or lose your job, you will be required to pay back the loan sooner than expected, usually within 60 days.
• Another potential con is that you miss out on potential tax-free compounding on the money you withdrawal which is why you have to be smart about it and do the math first. Don’t worry, I will show you how, so stay tuned.

How 401(k) Loans Work and Their Tax Implications

When you take a loan from your 401(k), you're essentially borrowing money from yourself.

The amount you borrow is subtracted from your 401(k) balance until it's paid back. You repay the loan, with interest, through automatic deductions from your paycheck.

The interest you pay goes back into your 401(k) account, contributing to your retirement savings.

Regarding taxes, a 401(k) loan is not considered taxable income if it follows IRS rules.

This means that, unlike a withdrawal, it's not subject to income tax or the 10% early distribution penalty.

However, if you fail to repay the loan according to the terms, the outstanding balance will be considered a distribution and will be taxed as income.

Additionally, if you're under 59 1/2, you'll also face a 10% early withdrawal penalty. It's important to consider these tax implications when thinking about a 401(k) loan.

When You Should Absolutely Consider Borrowing from Your 401(k)

• Debt Consolidation: If you have high-interest consumer debt, such as credit card debt, you should absolutely consider a 401(k) loan. The interest rate on a 401(k) loan is lower than credit card rates (typically prime rate +1%). Did I mention that you pay yourself the interest? The average interest rate on credit card balances is around 22%, so consolidating this debt will save you a considerable amount in of money in the long run.
• Emergency Expenses: If you're facing a significant unexpected expense, such as a medical bill or major home repair, a 401(k) loan can provide immediate funds. Instead of taping a credit card an incurring high interest debt, you should definitely consider taking a loan from your 401K.

The Importance of a Well-Thought-Out Plan

Before deciding to borrow from your 401(k), it's crucial to have a well-thought-out plan.

This should include understanding the amount you need, the repayment schedule, and how it fits into your overall financial plan.

It's also important to consider the potential impact on your retirement savings and whether there might be other, less risky options to meet your financial needs.

Remember, your 401(k) is primarily for retirement savings, so any decision to borrow from it should not be taken lightly.

The Math on Consolidating Debt with a 401K Loan

Scenario: Jim has $10,000 in credit card debt and a $50,000 in his 401K. He can either make payments on the credit card until it is paid off or he can take a loan from his $401K. Which should he do?

Without a 401K Loan:

$50,000, 401K invested in an index fund 7% annual return (very achievable return in most 401K portfolios).

Credit Card Balances (Negative Compounding) Anti-Wealth:

22% Interest on AMEX Credit Card Balance. Jim only has $210.02 (same amount he would pay if taking a 401K loan for apples-to-apples comparison) extra to pay off credit card.

Credit card calculation results...

Months to pay off debt: 114 or 9.5 Years

Total interest you will pay: $13,844.59

Total to pay back: $23,844.59

Networth Increase: $70,881.26 (410K balance) - $13,884.59 (CC interest paid) = $56,996.67

There's a net worth increase from the 401K investment but it is decreased by the credit card debt. 

With a 401K Loan:

401K, $40,000 invested in an index fund 7% annual return (very achievable return in most 401K portfolios). $210.02/Mo Re-Invested from $10K Loan Payoff.

401K $10,000 Loan Amortization 5 Years Pays 9.5% Interest (current prime +1% interest rate)

Networth After Taking a 401K Loan:

$71,740.95

Networth Difference: $14,744.28 More 

Practical Tips

• Understand the Terms and Conditions: Before taking a loan, make sure you fully understand the terms and conditions. This includes the interest rate, the repayment schedule, and any fees associated with the loan.
• Create a Repayment Plan: Have a clear plan on how you will repay the loan. This should include setting aside a specific amount each month to ensure you can make the repayments on time.
• Consider the Impact on Retirement Savings: Remember, when you take a loan from your 401(k), you are borrowing from your future self. Consider the impact this might have on your retirement savings and whether it's worth it in the long run.
• Seek Financial Advice: If you are unsure whether a 401(k) loan is the right move for you, consider seeking advice from a financial advisor.

Alternatives to 401(k) Loans

While borrowing from your 401(k) can be a viable option in certain situations, it's also important to consider other alternatives.

Building an emergency fund is one such alternative. An emergency fund, typically consisting of 3-6 months' worth of living expenses, can provide a safety net in case of unexpected expenses or loss of income.

This can prevent the need for taking out a high-interest loan or tapping into your 401(k) prematurely.

Low-interest loans can also be a good alternative to 401(k) borrowing.

Many credit unions and online lenders offer low-interest personal loans that can be used for a variety of purposes, including debt consolidation, home repairs, or even starting a business.

A home equity loan or HELOC is another great options if your debt situation is really bad.

These loans often have more favorable terms than credit card debt and, unlike a 401(k) loan, they won't diminish your retirement savings.

Conclusion (TLDR)

1. Borrowing from your 401(k) is a process where you take a loan from your retirement savings account. This loan, which you're required to pay back with interest over a predetermined period, can provide a low-interest option if managed correctly.
2. Borrowing from your 401(k) has both benefits and risks. The benefits include a lower interest rate and the ability to pay interest back into your own account. However, you could face hefty tax penalties if the loan is not repaid on time, and you might miss out on potential tax-free compounding on the withdrawn money.
3. A 401(k) loan can be particularly beneficial for purposes like consolidating high-interest debt, and addressing emergency expenses.
4. It's crucial to have a well-thought-out plan before deciding to borrow from your 401(k). This should include understanding the amount you need, the repayment schedule, and how it fits into your overall financial plan.
5. There are alternatives to 401(k) loans, such as building an emergency fund or exploring low-interest loans, which should be considered.
6. If you are unsure whether a 401(k) loan is the right move for you, consider seeking advice from a qualified financial advisor.