10 Ridiculous Rules About Payday Loans Near Me 550

If a 401(k) Loan is the right choice,

401(k) Loan Basics

The Top 4 Reasons to Borrow

Stock Market Myths

Debuting Myths With Facts

401(k) Credits to Purchase the Home of your choice

The Bottom Line

Retirement Planning 401(k)

4 Reasons to Borrow From Your 401(k)

The best time to take a 401(k) loan? When the stock market is in a downtrend

By Troy Segal

Updated 25 January 2022

Reviewed by David Kindness

Facts checked by Skylar Clarine

Skylar Clarine

The financial media have coined a few pejorative phrases to describe the pitfalls that come with borrowing from the 401(k) program. Some, including financial planners, would have you believe that taking out a loan from a 401(k) scheme is a fraud committed against your retirement.

However, the 401(k) loan can be appropriate in some situations. Let’s examine how such a loan could be used sensibly and why it need not spell trouble to your savings for retirement.

Key Takeaways

When it’s done with the proper reasons, taking the short-term 401(k) loan and paying it back on schedule isn’t necessarily a bad option.

Reasons to take out a loan from your 401(k) include speed and convenience and flexibility in repayment, cost advantage, and possible advantages for your savings during a down market.

Common arguments against taking loans loan include a negative impact on investment performance, tax inefficiency as well as the possibility of leaving the job due to an unpaid loan will have undesirable results.

A weak stock market may be one of the best times to take a 401(k) loan.

When you need a 401(k) Loan is the right choice,

When you must find the money for a major immediate liquidity issue then a loan from your 401(k) plan probably is one of the first places you’ll need to consider. Short-term is defined as roughly a year or less. Let’s define “serious liquidity need” as a significant one-time need for funds or a lump-sum cash settlement.

Kathryn B. Hauer, MBA, CFP(r), a financial planner with Wilson David Investment Advisors and author of Financial Advice for Blue Collar America explained it this way: “Let’s face it, in the real world, at times people need cash. Borrowing from your 401(k) is economically smarter as opposed to taking out a cripplingly high-interest title loan, pawn, or payday loan, or even a sensible personal loan. It’s cheaper in the longer term. “1

Why is the 401(k) an attractive source for short-term loans? It’s because it’s the fastest, most simple, cost-effective way to obtain the money you require. The receipt of a loan from your 401(k) is not a taxable event unless the loan limits and repayment rules are not followed, and it has no impact on your credit score.

If you are able to repay the short-term loan according to the timeframe typically, it will have little effect on your retirement savings progress. In fact, in certain circumstances, it may have a positive impact. Let’s look a bit more deeply to find out the reasons.

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Image taken by Sabrina Jiang (c) Investopedia 2020

401(k) Basics of a Loan

Technically, 401(k) loans are not legitimate loans, because they do not involve either an appraisal by a bank or a review of your credit history. They can be described as the ability to gain access to a certain amount of your retirement plan’s money, usually as much as 50% or $50,000 of your funds, or less–on an untaxed basis.2 You must then pay back the funds you accessed under rules designed to return your 401(k) account to approximately its initial state, like if the transaction has not taken place.

Another tricky concept to grasp in these transactions is the term interest. Any interest charged on the remaining loan amount is paid by the borrower into the participant’s own 401(k) account, which means that technically, this also is the transfer of funds from one of your pockets to another, and not a borrowing expense or loss. This means that the cost of the 401(k) loan on your savings in retirement can be low, neutral, and even positive. But in most cases, it will be less than the cost of paying real interest on a personal or commercial loan.

How to Be a 401(k) Millionaire

Top 4 Reasons to Borrow from Your 401(k)

The most important four reasons to go at your 401(k) for serious cash-flow needs in the short term are:

1. Speed and Convenience

In most 401(k) programs, getting an loan is easy and fast, requiring no lengthy application and credit check. Typically, it does not generate an inquiry against your credit score or impact the credit rating.

Many 401(k)s permit loan requests to be made by the click of an online site, and you can have funds in your hand in only a few days, and with total security. One innovation now being adopted by certain plans is a debit card that allows multiple loans can be made instantly in smaller amounts.3

2. Repayment Flexibility

Although the regulations stipulate an amortizing five-year repayment plan in the case of most 401(k) loans, you can pay back the loan faster with no prepayment penalty.2 The majority of plans permit loan repayement to be made by payroll deductions, using the after-tax money, however, not pretax dollars that fund your plan. Your statements from your plan will show the amount of credit for your loan account and the outstanding principal balance much as a normal bank loan statement.

3. Cost Advantage

There’s no cost (other aside from perhaps a small loan administration or origination fee) to draw on your own 401(k) funds for short-term liquidity needs. This is how it works:

You choose an investment account(s) from where you wish to borrow money. the investments are liquidated for the time period of the loan. So, you forfeit any earnings that could have been earned by these investments for a limited time. And if the market is in decline then you will be selling these investments more cheaply than other times. The benefit is that you will not suffer any further investment losses on this money.

The benefit of a 401(k) loan is the equivalent to the interest rate on similar consumer loan less any loss of profits from investments on the principal you borrowed. This is a straightforward formula:

Cost Advantage = Cost of Consumer Loan Interest. EarningsCost Advantage= Cost of Consumer Loan Interest -Lost Investment Earnings

Let’s suppose you get a personal bank loan or get a cash advance from credit card with an 8% interest rate. Your 401(k) account is generating 5 percent return. The cost benefit of using the 401(k) plan would be 3percent (8 5 x 8 = 3).

If you are able to estimate that the cost advantage is positive and an option for a plan loan could be appealing. Be aware that this calculation does not take into account any tax impact that could increase the benefit of the plan loan because consumer loan interest is paid back with tax-free dollars.

4. Retirement Savings Can Benefit

If you make loan payments into your 401(k) account typically, they are redirected back into your portfolio’s investments. You will repay the account a bit more than you borrowed from it, and this difference is known as “interest.” The loan produces no (that is to say, neutral) impact on your retirement plan if loss in investment earnings are equal to the “interest” which you have paid in–i.e., earnings opportunities are offset dollar-for-dollar by interest payments.

If the interest paid exceeds the investment losses taking out a 401(k) loan can actually improve your retirement savings. Be aware, however, that this could reduce the amount of your individual (non-retirement) savings.

Stock Market Myths

The above discussion prompts us to address another (erroneous) claim about 401(k) loans: By taking money out, you’ll dramatically hinder the performance of your portfolio and the development of your retirement savings. This isn’t necessarily the case. In the first place, as mentioned above, you will repay the funds, and you start doing so very quickly. In the context of the long-term duration of the majority 401(k)s, it’s a pretty tiny (and financially irrelevant) interval.4

19%

The percentage that 401(k) participants with unpaid plan loans in 2016, (latest information), according to an investigation conducted by the Employee Benefit Research Institute.5

The other problem with the bad-impact-on-investments reasoning: It tends to assume the same rate of return over the years and–as recent events have made stunningly clear–the stock market doesn’t work like that. A growth-oriented portfolio that’s weighted toward equities will have ups and downs, especially in the short term.

If your 401(k) is invested in stocks, the real impact of shorter-term loans in your retirement progress will be contingent on the current market conditions. The effect should be moderately negative in markets that are booming but it could be neutral, or even positive in sideways or down markets.

The bad but positive information: the most appropriate time to take the loan would be when you think that the market is at risk or weakening, for instance during recessions. Coincidentally, many people find they require funds or to stay liquid in these periods.

Debunking Myths With Facts

There are two more common arguments against 401(k) loans: The loans aren’t tax-efficient, and they create enormous headaches when participants can’t pay them off before they retire or leave work. Let’s confront these myths with facts:

Tax Inefficiency

The argument to be true is 401(k) loans are tax-inefficient due to the fact that they must be repaid with after-tax dollars, subjecting loan repayment to taxation double. Only the part of the repayment that is financed by interest is subject to such treatment. Media often ignore the fact that the expense of double taxation of loan interest is usually small, compared with the costs of other ways to access liquidity in the short term.

Here is a hypothetical situation that’s all too often real: Let’s say Jane makes steady retirement savings by deferring the 7% of her income to her 401(k). However, she will soon require a withdrawal of $10,000 to pay for a tuition expense for college. She expects to pay this loan back from her salary in about a year. She is in the 20% combined federal and state tax bracket. Here are three methods she can access the cash:

You can borrow money out of the funds in her 401(k) with an “interest rate” of 4%. Her cost of double-taxation on the interest amount is 80 dollars ($10,000 loan x 4% interest x 20 percent tax rate).

You can borrow money from the bank at a rate of real interest of 8.8%. The cost of interest is $800.

Don’t make 401(k) plans deferrals over the course of a year, and use this money to pay her tuition to college. In this case she’ll lose her real retirement savings progress, pay more income tax in the current year as well as forfeit any employer-matching contribution. The cost could easily be up to $1,000.

Double taxation of 401(k) loan interest becomes an actual cost only when substantial amounts are borrowed and then repaid over multi-year periods. However, even then, it typically costs less than alternative means of accessing the same amount of money through consumer or bank loans or a suspension in plan deferrals.

Working and leaving with an unpaid Loan

Imagine you take out a loan and then get fired. You will have to repay the loan in full. If you fail to do so then the total not paid loan balance will be considered a taxable distribution, and you may also be subject to an additional 10% federal tax penalty for the balance that is not paid if you are under age 59 1/2 .6 While this scenario is an accurate representation of taxes, the law doesn’t always reflect reality.

In the event of retirement or a separation from working, many people opt to receive a portion or all of the 401(k) funds as a tax-deductible distribution, especially if they are cash-strapped. A unpaid loan balance comes with the same tax consequences as making this choice. The majority of plans do not require plan distributions upon retirement or the separation from service.

People who want to avoid negative tax consequences should consider tapping other sources of income to repay your 401(k) loans before taking an income distribution. If they do this, the full plan balance can qualify for a tax-advantaged transfer or rollover. If an unpaid loan balance is included in the participant’s taxable income and the loan is subsequently repaid, the 10% penalty does not apply.7

The bigger issue is taking 401(k) loans while working with no intention or capacity to pay them according to a schedule. In this situation the unpaid loan balance is treated similarly to a hardship withdrawal, which can have tax implications that are negative and, possibly, an unfavorable impact on the rights of plan participants.

401(k) loans to purchase the Home of your choice

Regulations make it mandatory for 401(k) plan loans to be paid back on an amortizing basis (that is, with a fixed repayment plan in regular installments) for a minimum of five years, unless the loan is used for the purchase of a primary residence. Longer payback periods are allowed for these loans. The IRS does not provide a timeframe for the loan the payback period will be, however, it’s something you’ll have to negotiate with the plan administrator. Ask if you’re eligible for an additional year due to the CARES bill.2

Remember that CARES extended the amount participants can borrow from their plans to $100,000. The previous limit that participants could take out from their plans was 50 percent of their vested account balance or $50,000, whichever amount is less. If the balance of your vested accounts is less than $10,000, you are still able to borrow up to $10,000.2

The option of borrowing from a 401(k) to finance completely the purchase of a home isn’t as attractive as the mortgage loan. Plans loans don’t provide tax-free interest payments like the majority of mortgages. And, while the ability to withdraw and pay back within five years is acceptable in the usual scheme of 401(k) things, the impact on your retirement goals for the loan which must be paid back over many years can be significant.

However, a 401(k) loan might work for you if you require immediate funds to pay for the down payment or closing costs for a home. It will not affect your eligibility for a mortgage either. Since that the 401(k) loan isn’t technically a debt–you’re withdrawing the money you own at the end of the day, so it doesn’t have any influence on your debt-to-income ratio or your credit score, which are two of the major aspects that impact lenders.

If you need to borrow a sizable sum to purchase a house and want to use 401(k) funds, you might think about a hardship withdrawal instead of or in addition to the loan. However, you’ll be liable for taxes on income earned from the withdraw, and when the amount is more than $10,000, there will be a 10% penalty is due as well.7

The Bottom Line

Arguments that 401(k) loans “rob” or “raid” retirement accounts usually have two problems They assume constant positive returns to the stock market in the 401(k) portfolio, and they don’t take into account the cost of interest when borrowing similar amounts via the bank or other loans (such as racking up debt on credit cards).

Don’t be afraid to explore the possibility of a beneficial liquidity option in the 401(k) scheme. When you lend yourself appropriate amounts of money for the appropriate short-term goals These transactions could be the most simple, convenient, and lowest-cost cash source available. Before taking any loan it is important to be prepared in your mind for repaying these amounts at a time or sooner.

Mike Loo, vice president of wealth management at Trilogy Financial, puts it this way “While one’s circumstances in taking the 401(k) loan may vary but a way to stay clear of the downsides of taking one at all is to be proactive. If you are able to make the effort to plan, set goals for your financial future and set a goal to save some of your money both frequently and in the early hours, you may find that you have the funds you need in an account other than your 401(k), thereby preventing the need for a 401(k) loan.”