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  • Writer's pictureAntonio Buchanan

"Reasons To Borrow From Your 401K"

The financial media have coined a few pejorative phrases to describe the pitfalls of borrowing money from a 401(k) plan. Some of them – and some financial planning professionals, too – would even have you believe that taking a loan from a 401(k) plan is an act of robbery committed against your own retirement.

Not everyone believes it, though. According to a study by the Employee Benefits Research Institute (EBRI), nearly 20% of all 401(k) participants had plan loans outstanding. This statistic has held true since the early 2000s. Clearly, these loans have a following and, in fact, they can be appropriate in some situations.

Below, we'll take a look at how such a loan could be used sensibly and why it need not spell trouble for your retirement savings.

When a 401(k) Loan Works

When you must find the cash for a serious short-term liquidity need, a loan from your 401(k) plan probably is one of the first places you should look. Let's define "short-term" as being roughly a year or less. Let's define "serious liquidity need" as something beyond a sudden yearning for a 42-inch flat-screen TV – a one-time demand for funds or a lump-sum cash payment.

Kathryn B. Hauer, MBA, CFP®, a financial planner with Wilson David Investment Advisors in Aiken, S.C., and author of "Financial Advice for Blue Collar America," puts it this way: "Let’s face it, in the real world, sometimes people need money. Borrowing from your 401(k) can be financially smarter than taking out a cripplingly high-interest title loan, pawn or 'payday' loan or even a more reasonable personal loan. It will cost you less in the long run."

Why is your 401(k) an attractive source for short-term loans? Because it can be the quickest, simplest, lowest-cost way to get the cash you need. Receiving a loan is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on your credit rating. Assuming you pay back a short-term loan on schedule, it usually will have little effect on your retirement savings progress. In fact, in some cases, it can even have a positive impact. Let's dig a little deeper to explain why.

401(k) Loan Basics

Technically, 401(k) loans are not true loans because they do not involve either a lender or an evaluation of your credit history. They are more accurately described as the ability to access a portion of your own retirement plan money (usually up to $50,000 or 50% of the assets, whichever is less) on a tax-free basis. You then must repay the money you have accessed under rules designed to restore your 401(k) plan to approximately its original state as if the transaction had not occurred.

Another confusing concept in these transactions is the term "interest." Any interest charged on the outstanding loan balance is repaid by the participant into the participant's own 401(k) account, so technically this also is a transfer from one of your pockets to another, not a borrowing cost or loss. As such, the cost of a 401(k) loan on your retirement savings progress can be minimal, neutral or even positive – but in most cases, it will be less than the cost of paying "real interest" on a bank or consumer loan.

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Four Reasons to Borrow From Your 401(k)

The top four reasons to look to your 401(k) for serious short-term cash needs are:

1. Speed and Convenience: In most 401(k) plans, requesting a loan is quick and easy, requiring no lengthy applications or credit checks. Normally, it does not generate an inquiry against your credit or affect your credit score. Many 401(k)s allow loan requests to be made with a few clicks on a website, and you can have a check in your hand in a few days, with total privacy. One innovation now being adopted by some plans is a debit card, through which multiple loans can be made instantly in small amounts.

2. Repayment Flexibility: Although regulations specify a five-year amortizing repayment schedule, for most 401(k) loans, you can repay the plan loan faster with no prepayment penalty. Most plans allow loan repayment to be made conveniently through payroll deductions (using after-tax dollars, though, not the pre-tax ones your plan is funded with). Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement.

3. Cost Advantage: There is no cost (other than perhaps a modest loan origination or administration fee) to tap your own 401(k) money for short-term liquidity needs. Here's how it usually works: You specify the investment account(s) from which you want to borrow money; those investments are liquidated for the duration of the loan. Therefore, you lose any positive earnings that would have been produced by those investments for a short period of time. The upside is that you also avoid any investment losses on this money.

The cost advantage of a 401(k) loan is the equivalent of the interest rate charged on a comparable consumer loan minus any lost investment earnings on the principal you borrowed. Here is a simple formula:

Cost of consumer loan interest – investment earnings (lost) over the loan period = cost advantage

Let's say you could take out a bank personal loan or take a cash advance from a credit card. at 8% interest rate. Your 401(k) portfolio is generating a 5% return. Your cost advantage for borrowing from the 401(k) plan would be 3% (8 – 5 = 3).

Whenever you can estimate that the cost advantage will be positive, a plan loan can be attractive. (Note: This calculation ignores any tax impact, which can increase the plan loan's advantage because consumer loan interest is repaid with after-tax dollars.)

4. Your Retirement Can Benefit: As you make loan repayments to your 401(k) account, they usually are allocated back into your portfolio's investments. You will repay to the account a bit more than you borrowed from it, and the difference is called "interest."

The loan produces no (that is to say, neutral) impact on your retirement if any lost investment earnings match the "interest" paid in – i.e., earnings opportunities are offset dollar-for-dollar by interest payments. In fact, if the interest paid in exceeds any lost investment earnings, taking a 401(k) loan actually can increase your retirement-savings progress.

The Bottom Line

Arguments that 401(k) loans "rob" or "raid" retirement accounts often include two flaws: They assume constantly strong stock market returns in the 401(k) portfolio and they fail to consider the interest cost of borrowing similar amounts via bank or other consumer loans (such as racking up credit card balances).

Don't be scared away from a valuable liquidity option embedded in your 401(k) plan. When you lend yourself appropriate amounts of money for the right short-term reasons, these transactions can be the simplest, most convenient and lowest cost source of cash available. Before taking any loan, you should always have a clear plan in mind for repaying these amounts on schedule or earlier.

Mike Loo, an investment advisor representative for Trilogy Financial in Irvine, California, puts it this way: "While one's circumstances in taking a 401(k) loan may vary, a way to avoid the downsides of taking one in the first place is preemptive. If you are able to take the time to plan ahead, set financial goals for yourself and commit to saving some of your money both often and early, you may find that you have the funds available to you in an account other than your 401(k), thereby preventing the need to take a 401(k) loan."

via Investopedia

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