The ONE time you should borrow from your 401(k)

At one time or another, we’ve probably all found ourselves tempted to take an early pinch (or chunk) out of our nest egg. This is especially true of 401(k)s – so much so, in fact, that the IRS has set up specific provisions for how to take out a 401(k) loan should you decide to do so. 

Of course, just because something is legal doesn’t necessarily mean it’s a good idea. And I’d say this particular practice is almost always a bad idea. Long story short, if you can’t afford to redo that patio, or pay that tuition, or buy that commercial unit without stealing from your future self, then maybe you shouldn’t. 

But there are always exceptions, hence why I said it’s almost always a bad idea. So if you’ve ever found yourself facing this particular temptation, read on to find out exactly what it involves, what is at stake, and when it might – might – actually be a decent option. 

The basic rules of 401(k) loans 

Yes, the money in your 401(k) is yours, but it’s for, you know… retirement. So if you’re using it for non-retirement purposes, the IRS basically considers that to be a loan, lent by your future self to your present self. And such loans are subject to a few particular terms:

  • You can withdraw no more than 50% of your total 401(k) balance, OR $50,000, whichever is less.
  • You must pay yourself back within 5 years, including interest. 
    • This repayment amount is in addition to your normal 401(k) contributions.
    • However, you can suspend your contributions during some or all of the repayment period.
  • If you leave employment, you’ll have to do one of two things: 
    • Pay off the remainder of the loan upon termination, OR – 
    • Roll the loan over to another 401(k), if the new 401(k) will allow it.

Why shouldn’t you take a loan?

It might seem a bit petty to insist that your 401(k) be strictly limited to retirement needs. It’s a savings account, after all, and there are all kinds of things apart from retirement that someone may need to tap into their savings for. Right?

Well, this is one of those times where fuzzy terminology can get people in trouble. Yes, 401(k) funds are often referred to as “retirement savings,” but that doesn’t mean they’re interchangeable with the money you keep in savings at the bank, for example.

Retirement accounts have a twofold purpose: sure, they keep money safe that you’ve set aside, but they’re also designed to grow that money through exposure to the stock market. 

Basically, 401(k) loans often put the cart before the horse. They use money that’s intended for long-term growth as short-term rainy-day savings instead – something you’d ideally never have to do because you had a pool of savings ready before moving on to long-term investment.

I know, real life often doesn’t give a rip about broad ideals (more on that in a minute). But there are several other, more concrete reasons why you don’t want to owe 401(k) money to your future self:

  1. It will set you back on your retirement savings timeline – and for many people, that timeline doesn’t offer much wiggle room.
  2. You’ll end up paying more in contributions over the total life of the account, yet also have a lower balance in the end (again, more on that in a minute).
  3. Normal 401(k) contributions are tax deductible, but 401(k) loan repayments are not.

To sum up, taking $1,000 out of your 401(k) now doesn’t just translate to $1,000 less for your future retired self. Your future self would likely be set back substantially more than that. Repaying the loan promptly can mitigate this effect, but only to an extent. 

When a 401(k) loan makes sense

Like I said at the beginning, there are many situations in which taking an early nip from your 401(k) might seem appealing. Often, though, people have something in mind like redoing their patio – and hopefully I’ve convinced you by now that expenditures like that are not a good reason to do it. 

The possible exception would be if it’s a short-term expense that you know you can repay quickly. Again, the sooner you can repay the loan, the less damage your overall balance will suffer in the end. More realistically, however, a 401(k) loan should only be used in the event of a bona fide emergency. 

But what counts as an emergency? Basically, whenever you’re in dire need of an amount that a) won’t be covered by your emergency savings, and b) will cause worse fallout for you if it’s taken from some other source than your 401(k). For example, if the alternative is to put a huge transaction on your credit card, you’re probably better off with the 401(k) loan. 

A more direct comparison might be something like a HELOC, or home equity line of credit. Like your 401(k), your home is an investment vehicle, and so you can use a HELOC in much the same way as a 401(k) loan. But if you have a choice between the two, borrowing from the investment you’ve made in your home may still be a better option than borrowing from your retirement savings. Read on to see why.  

A practical example

Suppose you find yourself in urgent need of $50,000 for whatever reason, and you’re trying to decide whether to source that $50k from your emergency savings, your 401(k), your home equity or your credit card (in the unlikely event your credit limit even goes that high). 

You can probably guess that the first option is the best and the last is the worst, but let’s crunch the numbers to see how they all play out side by side. First, some basic assumptions:

  • You’re still ten years away from retirement
  • Your 401(k) has a starting balance of $300k, and 8% average annual return
  • 401(k) loan and HELOC loan would both have a 4% interest rate
  • Your credit card has a 20% interest rate – ghastly, but typical
  • Your normal 401(k) contributions are $650/mo, which will be suspended as long as you’re paying off any debt.

So, all else being equal, which of these alternatives will leave your 401(k) in the best position after ten years? It’s important to note that we’re not just looking at what will give it the greatest overall balance in the end; we want the best possible ratio of final balance to total payments and/or contributions. The most bang for your buck, in other words. 

Here’s what the different scenarios do to your 401(k) balance over time, compared to not taking out the loan at all:

Note that, even though you repay the loan to yourself, taking that money from your 401(k) sets you back significantly in the end. Note too that the credit card and HELOC loans follow the same path… and actually, they don’t look that bad!

There’s more to the story, however. The above chart only shows your final balance — but how much do you spend in each scenario? Observe:

Now to really cut to the chase, here’s a breakdown of your total profit for each option (i.e. final account balance, less total contributions and loan repayments) after ten years:

Unsurprisingly, the no-loan option fares best (and the credit card option worst) by a pretty wide margin. But even a HELOC loan ultimately leaves you in a better spot than borrowing from your 401(k) would. 

In conclusion

Remember, the above example contains a lot of assumptions that won’t apply to everyone, and it also doesn’t consider the potential effects of the HELOC loan on your home’s final value. So no – this isn’t meant to illustrate that 401(k) loans are always bad, full stop. 

Theoretically, there is room for a scenario in which borrowing from your 401(k) would be preferable to borrowing from your home’s equity. But it’s a tight race; and as I’ve said many times, the only way to know for sure about questions like this is to do the math for your particular situation. 

If nothing else, I hope I’ve demonstrated just how much it can cost you in the long run to borrow from your future self — in this case, over $100,000! At that point, it might be better to just say “stealing” instead of “borrowing.” But you didn’t hear that from me.