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By Christine Benz | 09-27-2017 10:00 AM

The Pros and Cons of 401(k) Loans

While not the first choice, 401(k) loans can be a decent option for investors with near-term cash needs, but it is not an investment strategy, says Michael Kitces.

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. 401(k) loans are incredibly polarizing. Some investors view them as useful financial tools while others think they should be marked with a skull and crossbones. Joining me discuss this topic is Michael Kitces. He is a financial planning expert.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. Good to be here.

Benz: Let's talk about 401(k) loans. You wrote a great piece on your Nerd's Eye View blog where you looked at 401(k) loans. Let's start with them from the traditional standpoint. If I need some additional funds to fund some goal or maybe even pay off debt, how could a 401(k) loan actually be useful?

Kitces: The core idea of a 401(k) loan is the same. We take retirement dollars; we kind of lock them inside of a plan--limited rules about distributions, tax penalties if we do, because the money is supposed to be earmarked for retirement, that's why we get some tax preferences. But in the real world, sometimes you need the money. You need to be able to use it for a little while.

And so, Congress early on implemented these rules. It said, you can borrow the money for a limited period of time out of your 401(k) plan and then put it back into the plan and we won't treat it as a taxable event and we won't apply the penalties. Now, in order to do that and to keep it from being abused, Congress put some limits in place. We can only borrow up to 50% of the plan balance; we can only borrow up to a maximum of $50,000; we still have to pay ourselves loan interest back into the plan--the plan actually gets to set the rate--but typically, we see things like prime plus 1% or 2%, which is actually pretty reasonable interest rate in today's environment.

It becomes a way to tap at least a limited portion of 401(k) dollars to borrow if--I'm not trying to take the money out, but just I have a near-term need and I need to get some dollars out. The water heater broke and we need to repair it and I don't have some cash lying around for that. Here is some money we can tap into in an emergency.

Benz: So, in contrast to borrowing from a bank or using credit cards or something like that, I'm not paying the interest to the bank. You mentioned that I'm actually paying the interest out of my own coffers. From that standpoint, it's actually better than borrowing from some other entity, right?

Kitces: Well, there is an interesting effect. The bad news is you have to pay interest. The good news is, at least, you receive the interest. You don't make the money, but you don't lose the money. It's a net wash, which makes it a pretty good deal all told.

Now, the caveat that goes along with that is, if I borrow the money out of the 401(k) plan, it's still not invested into whatever the 401(k) plan was going to be invested in, which means the money is not going to be growing. What really happens when you take loans out of 401(k) plans is, the cost to borrow is basically the opportunity cost of what I'm not going to be able to grow with my investments, because I'm using the money over here, and it's literally not invested for that time period. You really net out the loan interest, but you do have to give away some growth along the way which has a cost. That means the loan isn't a perfect zero, but often not a bad deal compared to a lot of other lending options that have much higher double-digit interest rates.

Benz: Right. So, you would put it higher in the queue. It seems like the gold standard would be I have some sort of an emergency fund; I tap that for my hot water heater that's broken. But barring that if those coffers are depleted, the 401(k) loan might be the next best step if I need additional funding?

Kitces: I mean, emergency fund is often number one, frankly, for most folks that we work with. Number two, if it's available, is a home equity line of credit, particularly, ironically, when we are fixing maybe the water heater in the house. But home equity lines of credit tend to be very reasonable interest rates, they are easy to draw on, they are easy to pay back. I'm not taking money out of the market and out of future growth opportunities. We tend to look at things like home equity loans as number two. But 401(k) loans quickly stack up as number three, and often are much better interest rates, the sort of implied interest-rate potential even when we consider the foregone growth over using things like borrowing on credit cards and borrowing from other sources. It does become a pretty appealing option.

Benz: The idea that prompted your blog post was this idea of fixed-income funds, wherever they maybe in 401(k) plans or anywhere else, are not earning much in terms of interest. You've heard this idea from clients, potential investors. What if I actually borrow from my 401(k), the interest that I'm required to pay back beats the fixed-income funds in my lineup. What do you say to that idea?

Kitces: We've heard this a lot lately. Past couple of years as interest rates are low and you just look at these bond funds that might be paying 3%, 2%, 1% sometimes after expenses and saying, why am I investing for 2% when I can pay myself 5% in 401(k) loan interest. And ultimately, the reality is that strategy doesn't work. And the reason it doesn't work--the good news for your 401(k) plan is, you do effectively get 5% returns on the dollars that go back into the plan. The bad news is, you pay the 5% ...

Benz: It's your own money.

Kitces: It's your money. You are paying your own return. What happens when you get a 5% return and you pay a 5% interest cost? You net zero. If you just kept the good old bond fund paying 1% or 2%, at least you would have earned 1% to 2%. It's actually better than zero.

And as it turns out, when you do this with a sort of a pay-yourself bond interest strategy, it actually gets worse than that because some of the tax dynamics that occur around 401(k) plans. Technically, when you borrow the money out of the 401(k) plan and you pay yourself back this loan interest, the money that goes in on the loan interest is not itself deductible as a contribution in your plan. Your plan will get larger with your own money that you put in. And then when you get it back out, you're going to have to pay taxes on it again because it's part of the value of the plan. And so, even if you have the money available to say, hey, I'd like to put in extra 5% of my account balance into my 401(k) plan, you are better just contributing the money …

Benz: Additionally.

Kitces: … additionally, get your tax deduction--obviously, you still have to deal with the overall 401(k) limits--but just contribute the money you would have paid to yourself on loan interest and let that plus the money that's there get invested in bonds at 1% or 2%. It's still better than earning the interest where you pay the interest along the way. And it also gets you out of the secondary risks of, if it turns out you've done this borrow from yourself and pay yourself back strategy and then you have a change in job circumstances, and suddenly, the 401(k) loan gets called because you don't work there anymore. You have to pay it back and you may not have the dollars available. Now, we get additional problems that go along with this, and we could have adverse tax penalties because now the loan gets treated as a distribution. Things kind of quickly spiral down from there.

Using the 401(k) loan just as an actual loan if you need to borrow money actually is a pretty reasonable place to go as long as you're comfortable you're going to be able to pay it back quickly and not get it called on you in a job change. But as an investment strategy, it just doesn't work, it just doesn't work. It sounds you neat to pay yourself 5% loan interest, but it's not just that you receive 5% loan interest, you're paying the loan interest and you're paying it without deductibility and you're putting money into your plan without deductibility and that actually sets you behind the eight ball compared to just adding more contributions if you've got the money.

Benz: Michael, important topic. Thank you so much for being here to clear this up for us.

Kitces: My pleasure. Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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