401(k) Loans: Mythbusters Edition

The topic of 401(k) loans seems to ignite divergent--and passionate--responses from personal finance experts and investors. At one end of the spectrum are those who believe that 401(k) loans should be marked with a skull and crossbones; investors who take out the loans seriously jeopardize their retirement security. At the other end of the spectrum are those who view 401(k) loans as a valuable tool for achieving financial goals before retirement.

At the risk of sounding wishy-washy, I believe that both camps make valid points. As 401(k) naysayers are quick to point out, it's never ideal to raid your retirement fund prematurely; doing so can deprive your retirement assets from some valuable compounding. But as 401(k) loan proponents note 401(k) loans can beat more costly forms of financing walking away.

Further complicating the great 401(k) loan debate is that there's a fair amount of confusion about how 401(k) loans work: the payback terms, tax issues, and how much (if any) compounding the 401(k) borrower actually misses out on. Here are some of the most common myths surrounding the loans, as well as the reality about them.

Myth 1: 401(k) loans never ever make sense.

Some pundits view the issue as black and white: 401(k) loans are a financial don't, right up there with taking a payday loan or carrying a balance on a credit card. And I'd certainly agree that 401(k) loans--or any other forms of financing--are inappropriate for anything but basic needs: paying for a home, funding higher education, or reducing crippling credit card debt, for example.

But if a real need is there, taking a 401(k) loan is much preferable to resorting to other forms of financing; it also may better than tapping a home-equity loan or line of credit. The reason is that even as you'll owe interest on the 401(k) loan, you'll pay it back into your account rather than a bank, in contrast with credit card and home-equity debt. (Interest on home interest debt may still be tax-deductible for some, which isn't the case with 401(k) loan interest, however.) Make no mistake: That 401(k) loan interest comes out of your own coffers, but it's still better than surrendering it altogether to a third party.

Borrowing against your 401(k) even beats raiding a Roth IRA prematurely, in my opinion. True, you can withdraw your Roth contributions at any time and for any reason without taxes or penalties (you've already paid taxes on the money in your Roth, after all); that puts Roth contributions pretty far up in the emergency-funding hierarchy. But you're not required to pay back your Roth IRA for money you've borrowed, and even if you wanted to, you're going be subject to the annual contribution limits of $5,500/$6,500 if older than 50. Nor will the money you pull out of the Roth earn any interest like your 401(k) loan assets will (again, that interest is your own money, but it's still a form of self-discipline).

Myth 2: 401(k) loans can be a wash--or even a win--from a financial-return perspective relative to leaving your money in the 401(k) account.

If you're taking a 401(k) loan to pay off high interest-rate credit card debt, the loan will almost certainly be a winning move versus continuing to carry a balance on the credit card. Say, for example, you're paying a 10% interest rate on your credit card, but the 401(k) loan interest rate is 4%. Not only are you paying that interest to yourself on the 401(k) loan, but it's also a lower rate, so it's a wise financial move all around.

Yet 401(k) loan proponents who suggest that taking a loan can beat keeping the money invested are taking their argument too far. True, the interest you owe yourself will be positive, whereas long-term assets like stocks can lose money at various points in time. But the interest you pay yourself on your 401(k) loan comes out of your own pocket and consists of dollars you've already paid taxes on; unless you're lucky enough to take your 401(k) loan at the same time the market tanks, the return from leaving the money in the 401(k) will very likely beat the interest you owe to yourself on the 401(k) loan.

Perhaps even more important, 401(k) borrowers may not be able contribute to their plans as long as they have a loan outstanding; indeed, Fidelity Investments reports that one quarter of 401(k) participants who have taken loans from their plans reduce the amont they're saving in the plan, and 15% stop contirbutions entirely within 5 years of taking a loan. Thus, the 401(k) borrower doesn't have the opportunity to put new money to work amid market downturns.

Myth 3: You'll pay taxes twice.

This assertion has been widely debunked, but I still hear it surface here and there: You've put pretax dollars into your 401(k), but you pay back your 401(k) loan with aftertax dollars; you'll owe taxes on that money again when you pull it out during retirement. Therefore, double taxation!

However, that statement greatly exaggerates the tax costs of taking a 401(k) loan; the only money "taxed twice" in the transaction is the interest paid. Meanwhile, the 401(k) borrower is able to take the loan, consisting of money that has never been taxed, without tax consequences.

Say, for example, I borrow $10,000 from my 401(k) on Tuesday, because my sister needs a loan until she receives a commission check on Friday. I'll pay no taxes on the amount that I borrow, and when she pays me back I'll put the $10,000 right back into the account without any tax consequences. The only aftertax money involved in the transaction--and that I'll also owe taxes on again in retirement--is the paltry amount of interest I owe for the three days I had the loan out.

Of course, from a practical standpoint investors often pay back their 401(k) loans with aftertax dollars, in contrast with my example above. Say, for example, I borrow $25,000 from my 401(k) to buy a car. The money I've borrowed tax-free from my 401(k) is sunk in my car and I can't get it out to pay myself back; to pay back my 401(k) loan, I have to use aftertax dollars. But I took the initial $25,000 out tax-free, so it's a wash from a tax perspective; I got a tax break on the amount I borrowed, but that break is effectively negated by the fact that I'm paying it back with aftertax dollars. Only the interest part that I'm paying on my loan is truly taxed twice.

Myth 4: That you'll have to rob a bank or sell your house if you have a 401(k) loan and lose your job.

Opponents of 401(k) loans quite correctly assert that the biggest risk of such a loan is losing your job. In that instance, the borrower will have a set period of time, usually 60 days, to pay the money back. That's a scary thought, given that many people aren't feeling especially flush when they lose their jobs. It should also be a huge disincentive to take a 401(k) loan unless a) you have a strong sense that your company--and your position within it--is extremely stable or b) you have secret stash of cash somewhere (in which case, why are you taking a 401(k) loan?!).

However, it’s worth bearing in mind that some plans give 401(k) borrowers additional time to pay back in case of job loss. And while it would be ideal for the 401(k) borrower who has lost a job to pay the money back within the preset time limit, in a worst-case scenario it’s not as though you have to come up with the actual funds to repay the loan; you wouldn’t have to sell your house, for example. Rather, the unpaid loan amount will be subject to a 10% early distribution penalty as well ordinary income tax. That’s a terrible consequence, of course, but it’s not as though the 401(k) loan must technically be paid back with external assets.