Most WCIers are familiar with the concept of a 401(k), which is a retirement account held by an employer and directed by an employee. The primary source of money in a 401(k) is employee contributions, though many employers also contribute and/or match employee contributions. Less familiar might be the concept of a 401(k) loan, where you loan yourself money out of your retirement account to use for other purposes.
In this post, we will explore 401(k) loans and talk about when you should consider using one.
What Is a 401(k) Loan?
At its basics, a 401(k) loan is exactly what it sounds like. You take a loan from your 401(k) retirement account. You can then use the proceeds of that loan for just about any purpose. You repay the money into your 401(k) account according to a set schedule, with interest. You might think that this could be a stealthy/big-brain way to get more money into your 401(k), but 401(k) loans are not a practical investment.
The limits and mechanics of 401(k) loans are going to vary depending on your employer's policies and 401(k) provider, but generally, you are limited to taking out the lesser of $50,000 or 50% of your vested balance. The standard repayment terms are five years, though sometimes you can get a longer repayment period if you're using the money to buy a home. 401(k) loans are usually pegged to the Wall Street Journal Prime Rate, plus a margin of 1%-2%.
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The Pros: When a 401(k) Loan Might Make Sense
Before we get into the reasons why you probably don't want to do a 401(k) loan, let's look at some of its advantages or scenarios where it might make sense. There is no credit check or underwriting, which means that it offers easy access to cash if you need it.
A 401(k) loan is usually going to offer lower interest rates than personal loans or credit cards, and the interest paid goes back into your own account (rather than to a lender). A 401(k) loan can be useful for short-term liquidity needs or emergencies, and it may help consolidate high-interest debt in limited cases. You can think of it as a last resort, but sometimes it is a reasonable option.
The Cons: Why 401(k) Loans Are Usually a Bad Idea
Now that we've gotten the pros of 401(k) loans out of the way, let's talk about some of the reasons you probably don't want to do one:
- Lost investment growth: When you take money out of your 401(k), it’s no longer invested in the market. That means you miss out on compounding returns, which is probably the biggest hidden 401(k) loan negative.
- Double taxation: 401(k) loan repayments are made with AFTER-tax dollars, and those same dollars will be taxed AGAIN when they are withdrawn in retirement.
- Job loss risk: If you leave your job (voluntarily or not), the outstanding loan balance may become immediately due. If you can’t repay it, the remaining balance is treated as a taxable distribution.
- Taxes and penalties: If the loan defaults, you may owe ordinary income taxes plus a 10% early withdrawal penalty if you’re under age 59 1/2. This can turn a small mistake into a very expensive one.
- It encourages bad financial habits: Borrowing from your retirement account can make it easier to justify lifestyle spending or poor planning. Over time, this behavior can significantly derail long-term wealth building.
Should I Take a Loan from My 401(k)?
If you are wondering if you should take a loan from your 401(k), the general rule of thumb is going to be that you should not. Generally, the WCI investing order of operations emphasizes:
- Emergency fund first
- Insurance coverage
- Tax-advantaged investing
Some situations where a 401(k) loan might be worth considering are to avoid high-interest credit card debt or if you can make a short-term, high-certainty repayment. Avoid a 401(k) loan to increase lifestyle spending, for investing or speculation, or if you have uncertain job stability.
If you're considering taking a loan from your 401(k), make sure you also consider a personal loan or a HELOC, or simply cut your expenses.
More information here:Should I Use My 401(k) to Pay Off Student Loans?
If you are specifically wondering about using a 401(k) loan to pay off student loans, it's still probably not a great investment for most doctors or investors. One of the biggest problems with a 401(k) loan is that you miss out on all the compounding interest during the time that your money is out of your account. That lost compounding over a time horizon of decades can mean a deficit of hundreds of thousands of dollars or more.
The Bottom Line
401(k) loans are a tool to be wielded in very specific situations, and they are NOT a viable investing strategy for most physicians. In addition to job loss risk, potential taxes and penalties, and double taxation, the biggest negative is the missed growth in your 401(k) account balance while your money is out of the market. If you're considering a 401(k) loan, make sure you have also looked into other options like a HELOC or a personal loan. This will allow you to protect your retirement accounts at all costs, setting you up for a successful financial future.
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