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Borrowing Against Your 401K

Borrowing Against Your 401K: A Loan from your Future Self

 

Your 401K is meant to fund your retirement. But you can withdraw money from it earlier. Is borrowing against your 401K ever a good idea?

It goes against personal finance philosophy to take money out of a retirement account before retirement but under the right circumstances, it is something to consider.

Borrowing against your 401K means you are borrowing from yourself. Unlike borrowing from a bank, the interest you pay, you pay to yourself. The amount you borrowed is no longer invested so rather than getting investment gains, your “gain” is the interest you pay back.

You can borrow up to $50,000 if you have a vested balance of at least $100,000 or 50% of the value, whichever is less. A home down payment is a good use of this type of loan. Using it for a bigger down payment reduces the amount of long-term interest you will pay on your mortgage and can help you avoid PMI.

Refinancing credit card debt is another good reason to borrow against your 401K because you’re paying yourself back at a much lower interest rate than you’re paying to a credit card company.

You have five years to pay back a 401k loan, ten if the loan was used to buy a home. The exception to these rules is if you leave or are fired from the job. In some cases, you will be required to repay the loan within 60 days. 

Be warned, a 401K loan can have bad consequences. If you can’t pay the loan back, it becomes a penalty withdraw so this is not a decision to make lightly or a loan to take out to pay for something frivolous like a television or vacation.

But under the right conditions, it can be a great decision that can save you money in the long run.

Show Notes

LMM Community: Join the conversation!

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  • Eric Cumming

    I think that the only time the borrowing from your 401k is appropriate is when you already have a great deal of debt that is at a very high interest rate (higher than the returns you could expect in the market). I don’t think its appropriate for use as a down payment on a house.

    Yes you are “paying interest to yourself” but that is your own money that you would otherwise not be using. If you are borrowing $X as a downpayment on your your house, you are not gaining the 4% interest you are paying on that money. Its just forcing you to save more of your money in your 401k, but you are not getting any of the tax benefits of that additional money. In addition you are losing all of the investment gains.

    Add in the potential risks that arise if you were to lose your job and it becomes a very hard avenue to justify unless you have great job security and some very high interest debt you can roll into this loan against yourself.

    • I agree – that’s the point of view we were trying to get across. Is it the best debt solution ever? No. Is it far better than most debt that people in the audience actually have? Probably.

      I love that the core fans who are generally pretty good with money are the ones that reach out and debate the semantics – which is important. But there are also people who have really expensive shitty debt that get rejected from SoFi and are often unable to leverage other solutions like Lending Club because they are unsecured. Because 401k loans are secured almost everyone can get them and they’re an important first step to ditching extremely high interest loans.

      All that said, I’m probably going to have to publish something and break out my math skills because there’s a lot of conjecture and little practical examples of where this is a good idea. It’s a financial tool and it’s important to know that it’s available when it’s needed. People need to know that it’s a possibility.

      • Eric Cumming

        Funny story, about 2 days after posting this I recommended a friend pay off some high interest student loan debt by borrowing from her 401k.

        • Dude, that’s awesome, thanks for sharing! It’s nice to occasionally hear positive feedback :)

          I’d love to hear if he does it and the actual numbers behind the move!

          • Eric Cumming

            Don’t want to share actual numbers without permission, but there was a portion of her student loan debt that was pretty high interest. She actually asked about a 401k loan and although my initial reaction was “NO!” the more I thought about it the more it made sense. She would be putting that interest toward her future self instead of the loan company.

            There were two stipulations that I said she should make sure are doable…
            1) she is still able to contribute per-tax money to get her match (as others have mentioned, that might not be allowed)
            2) The term of the loan will be relatively short and she is 100% confident she wont lose her job or leave for any reason during that time.

            Assuming these are true, then she should be seeing a “return” on the borrowed money equal to the Interest Rate on the student loan minus the expected market return…

    • jb1907

      In the 15% bracket, plus the 10% penalty, I still wouldn’t borrow from the 401K to pay off credit cards. Just stop contributing and put that money to credit card debt.

      • Eric Cumming

        You don’t pay the 10% penalty on a loan.

        • jb1907

          You would if something happens and you lose your job and don’t pay back the loan.

          • Eric Cumming

            Yeah, but I think that if you were didnt have fantastic job security and a relatively short loan term then a 401k loan would be a non-starter.

            A risky loan for sure, but if could result in big net gain if its used against high interest debt.

          • jb1907

            You would be surprised at the number of idiots out there. The Debt is more of the issue than the interest rates. I would stop contributing and try and find other sources of income. Pulling out the money takes that money out of the market. That could be a huge difference 30 years down the line if they take out $50K which could turn into $250K just by compounding.

          • Eric Cumming

            If you are expecting a 7% return in the market and have and interest rate on bad debt of 15+%, then its worth it assuming you have a very small chance of paying that 10% penalty.

            I guess this also assumes that you then start saving what you were paying toward the loan. For instance, if you borrow from your 401k and eliminate a $500/month loan payment. When its paid back, do you then spend that $500 you just freed up every month on eating out and drinking too much, or do you save it?

  • Chris

    Most 401k plans are set up as traditional offers and not ROTH options and contributions are made on a pre-tax basis so you don’t pay taxes on the amount that you contribute. This means that an individual in the 25% tax bracket making a 100$ biweekly contribution will only see a 75$ reduction in their take home pay (probably even lower once state income taxes are accounted for).

    However a 401k loan does a few things:

    1. Double taxation. As I said above normally 401k contributions are pre-tax, however once you take a 401k loan the repayments and “interest” that you “pay yourself” are only allowed to come from post-tax dollars.They CANNOT be deducted pre-tax like your normal 401k contributions. Additionally when you do reach retirement the withdrawals will be taxed again and so Uncle Sam gets his taxes from you on the amount that you withdraw twice!

    2. Many plans don’t allow contributions during the repayment cycle. So even if you could afford to repay the loan (post tax) month by month AND make your normal contributions (pre-tax) its very likely that you wouldn’t be allowed to.

    3. From a behavioral finance perspective once you crack open that piggy bank you aren’t likely to stop. I think Vanguard or Fidelity did a study a couple years ago that showed that once you start borrowing you are very likely to continue and a lose a LOT of time in the market and compound interest.

    Maybe its worth it to save your house but only if the situation that got you there in the first place has already been addressed. Hitting your 401k for a loan to simply put off the inevitability of losing a home is a bad idea since it will result in losing the home and your retirement savings. Sell the house and rent if you have to. Stop the bleeding and remember that a 401k balance (though not an IRA) is totally protected from creditors.

  • Sylvain B

    I think Andrew completely left out the taxes.

    From what I could read, if you borrow against your 401k you have to pay income tax and a 10% penalty.
    Even if somehow you can avoid these taxes you pay your loan back with after tax money. This is a huge hit! A 20 % + interest rate!!!
    The only way it could work is if you have a ROTH 401k, something I didn’t ear during the show.
    Andrew, I cannot find any reason for borrowing money this way. Unless I missed something, please add some corrections, it could be misleading to a lot of listeners

    • Chris

      A loan from your 401k won’t trigger income tax unless…..

      1. Its not paid back within the timeframe of the loan in which case its considered a distribution and then you have to pay a 10% penalty and income tax

      2. You lose your job and then you have to pay back the loan within 60 or you have to pay a 10% penalty and income tax

      .
      Other than that the tax ramifications of repaying a 401k loan are the issues with double taxation and the very high chance that you won’t be able to do normal contributions during the loan repayment even if you could afford it.
      The information was good in the podcast, they did emphasize that it was a last resort. However I wouldn’t ever use it as a down payment on a new house, only to save a house if I knew for certain that it would actually work. I’d want them to emphasize the 2x tax issue if they ever address it again.

  • Zachary Gliddon

    I was wondering why there is an interest payment at all? If you are lending yourself money then what is the purpose of a plan setting an interest payment?

  • Roy Weber

    While discussing 401(k) vesting period Andrew & Thomas stated that staying at a job for five years is highly unlikely. Why was that not brought up again when talking about loan repayment? My understanding is if you leave your job with a 401(k) loan you have 60 days to repay in full. The advice in this episode was way worse than the “Thomas Buys a Car” episode.
    While I will most likely still listen to your podcast it will strictly be for entertainment purposes, not for advice. I am no expert but you guys have lost your credibility with me.

    • bythedog

      As I was listening, I thought to myself whether the blowback from this episode would be as bad as with the car episode. :)

      That being said, I’m not sure Andrew was really encouraging people to do this. It was more of a discussion of what’s involved and just that it’s a possibility. Every person’s situation is different, and I doubt that these guys would be advocating that this is a good idea across the board.

      • Wow, thank you bythedog. I thought I was very careful to just “discuss the possibilities” and not say “you should do this”. It’s a thing that exists and it worked for me. I never want to give bad advice but I am happy that it riled people up and got the conversation going.

        It’s funny, in order to flame us people wind up doing monstrous amounts of research which actually winds up being a net-positive because they learned something – that’s why we’er here. We never pretended to be experts but we do see ourselves as educators… most of the time :)

        • Diana B

          Right, but then what is the point of listening to the show? Do we have to do our own research to figure out if the advice you are giving is even valid? And no, I do not just blindly follow advice from podcasters, but I expect a little bit of thought has been put in to creating an episode. Since the hosts admittedly do not research the topics before the show, it seems like a waste of everyone’s time.
          I honestly miss season 1 of LMM. I used to really enjoy listening to it. Now the only reason I listen to the show is for comic relief as to how terrible the advice is.

          • Eric Cumming

            From what I remember, the advice from this episode is…

            1) Maybe think about a 401k loan to eliminate some high interest debt. Its risky but could pay off.

            2) You could use a 401k loan to prove you have extra liquid cash when buying a home, then pay it back right away.

            I don’t think either of those thing counts as “terrible advice”

          • Hey Diana, an excellent point – I want to put a few thoughts out there:

            1. We have over 400 hours of episodes publicly available. If you thought 20 hours were terrabad, that’s still leaves us at 95% awesome. We strive to consistently produce gems but not everything reaches our lofty expectations. I’m sorry if this one didn’t do it for you.

            2. There was nothing incorrect in this episode. I understand you don’t agree with the approach we described but it is a valid and useful financial tool when used wisely. Perhaps we should have added a bit more color to the episode around use cases but I do strongly believe that this is something that is important for people to know AND highly useful in many situations. The only “idiot proof” financial tool is a Savings account, beyond that everything needs to be approached thoughtfully.

            3. Yes, you should do your own research. You should never blindly follow any financial advise. We really try to be as honest, helpful and transparent as possible but you should never go into something you don’t fully understand. Asking questions is very healthy.

            4. As for the latest episodes, we hit a bit of a rough patch. We do have some pretty cool stuff coming up that I think you’ll enjoy. If there is something specific you’d like us to do, we’d love to get an email from you. Most of our best stuff has come as a result of suggestions from people like you!

  • Jeff Mohr

    I believe most plans don’t let you contribute or earn a match when you have a loan outstanding.

    • Allison

      TSP loans (military and government 401k) you can still contribute while repaying a loan. We took one out a few years back and there was no issue with contributing,

  • Anthony

    This may be the worst advice episode yet. There should be no reason worthy enough for someone to borrow against their 401 (k). The money they will lose by taking the money out (Paying the 10% penalty and taxes) is extremely high. Thomas and Andrew need to listen to what Ric Edelman has to say on this subject and I think their opinions might change.

    The comment about a 5 year vestment period being ridiculous is short sighted to me. Some people will definitely stay with the same employer for that long (even in the world we live in today). I have a 10 year vestment period (not with a company but with the goverment (403 (b)). That isn’t even mentioned but has the same idea.

    • Hey Anthony,

      To preface this, I didn’t know anything about 401(k) loans going into this episode – Andrew was completely schooling me on them.

      After having done some extra reading though, I’m a bit confused about your comment. According to Investopedia’s article on this topic ( http://www.investopedia.com/articles/retirement/08/borrow-from-401k-loan.asp ), you don’t pay the 10% tax penalty unless you lose your job and fail to repay the loan in 60 days – which we mentioned in the episode.

      As for the vestment comment – I grew up seeing lots of people get laid off from their jobs through no fault of their own, and we had a recent This Financial Life guest who was laid off two weeks before her 401(k) vested. That’s where my comment came from – seeing the absolute lack of loyalty some companies show towards their employees, as well as the reality that many, many people won’t keep the same job for 5 years these days.

      I realize that it may be a different case with government jobs, but there are a lot of people in the private sector who that might apply to.

      • Sylvain B

        Thomas you still have to repay pre tax dollars with after tax dollars. I don’t know how it can be a good deal to take a loan that cost you your tax rate. Getting a loan at 10, 15 or 20% is better than this deal.

        Moreover 401k and retirements accounts are protected against bankruptcy, so these accounts would be the last ones I touch in case of a dire emergency.

        • So I’m doing a bit more reading on this, and at least regarding the principle balance, I don’t think there’s a problem here. The borrower gets to spend pre-tax money, so paying it back with after-tax money represents the initial tax liability that should have been incurred. Here’s an excerpt from a Wharton Business School paper( https://www.asppa.org/Portals/2/PDFs/White%20Papers/WP2014-01.pdf ):

          “The present value of the tax liability associated with the income to generate these principal payments is simply the avoided tax liability on the amount borrowed, τL/(1-τ), assuming constant salary and no changes in marginal tax rates over the loan period. In other words, the participant avoids a tax liability upon withdrawal of pre-tax savings, but then pays a subsequent tax liability through repayment with after-tax wages. The two effects net to zero, at least with respect to principal repayments.”

          However, this isn’t to say that I’m ok with these types of loans for normal consumption purposes. The more I read into the research, the more I’m agreeing with you. Especially harrowing was the finding that, in their dataset, 86% of borrowers who lost their jobs fell into default on these loans. Which means that even if we say, “only take a loan you know you can pay back in a couple months,” the data suggests people aren’t doing that. They’re biting off more than they can chew.

          I’m going to finish reading the paper and develop some more solid conclusions.

          • Sylvain B

            I didn’t fully grasp the taxes and that you pay the taxes on what you borrowed when you pay it back, my bad.

            I am also lacking data about what is happening when you pay it back. As chris said, do you stop contributing on a pretax basis when you pay your loan back? “2. Many plans don’t allow contributions during the repayment cycle.”
            If it is the case, that could be a big loss.

            I like to keep things simple: A retirement account for retirement, an emergency fund for emergencies.

          • I think part of what confuses people is that the interest on the loan IS double-taxed, because that’s money that you were paid post-tax, which you are paying back into the 401k, only to have taxed again when you retire. However, it’s good to note that double-taxing that interest still causes less of a loss than paying 100% of the interests payments to a loan company for other types of loans.

            As for allowing contributions while a loan is out, from what I’ve read, it’s a matter of company policy. So that’s something you’d definitely want to be clear on before considering a loan.

            Still, after doing some research, I’m not sure I agree with Andrew’s assessment that borrowing from a 401k to reduce interest on a home loan is something to be recommending. Maybe the math worked out for him, but the data on the latest research shows that most people with 401k loans have low liquid wealth:

            “Using data from the Federal Reserve Survey of Consumer Finances, Sunden and Surette (2000) and Li and Smith (2010) noted that the individuals borrowing from their 401(k) accounts, while having higher DC account balances, were more likely to have lower total financial assets, to have higher debt, and to be more credit-constrained.”

            (same paper as linked above)

            If you want to avoid PMI, just save more before buying a house or buy a less expensive house.

            This highlights a tough spot I find myself in as someone who creates content for an audience. A well-educated individual can leverage debt and take on certain amounts of risk in order to come out ahead, but should we be recommending this on a larger scale? Or should we act like policymakers, who use data to figure out what’s happening on a large scale and shape policies to influence behavior?

            In other words, are we really just two dudes talking about stuff that works for us, or do we have greater responsibility?

          • Sylvain B

            “If you want to avoid PMI, just save more before buying a house or buy a less expensive house.” This is exactly where I stand.

            “In other words, are we really just two dudes talking about stuff that works for us, or do we have greater responsibility?”

            As I turn to LMM to get sound financial advice, I think you have greater responsibilities. IMO, talking about a 401k loan experience is OK but only after explaining the bad sides of it.

            Given the size of your audience as well as the fact that you are usually right on point, it would be a really bad thing if some people start thinking their 401k is another savings account.

            On the other hand, the show is yours. I always enjoy listening to both of you and I am sure you it must be very complicated to be in your shoes when you decide to talk about something and very hard to know in advance what will be the reaction of the audience.

          • Anthony

            I want to take the time to apologize to Thomas. I need to step back and realize that we all are together in the learning process of personal finance and it can be process that takes several years of study and practice.

            I still enjoy LMM but I feel as though Andrew may have bit off more than he can chew with the Community, part of the reason I stopped my subscription was I couldn’t login and Laura sent me the link that I already tried that didn’t work (I get no e-mail when I try to reset my password).

            I also felt it was weird how at first there was a patreon page for LMM and then there was a community with a separate subscription. I can’t afford both and honestly don’t know which one to choose.

            Sorry again and sorry to Andrew for giving the impression that I was giving up on him because I’m not. I still wish he can contribute to LMM on a full-time basis one day. I would love to see that happen.

          • No worries Anthony – while we’re all learning together, I do feel that we should be held to a somewhat higher standard as broadcasters. While I definitely appreciate people realizing that we’re not perfect, I also can’t expect that we’ll always be given the benefit of the doubt when we mess up or say something controversial.

            Regarding the community; yep, the launch was a bit rocky and there was a bug with the signup/login process. I believe it’s fixed now though.

            The community is intended to replace the Patreon page, at least for people who find it valuable enough to pay for the membership. We’d much rather have you join the conversation there and help shape what should ultimately become one of the most valuable parts of LMM – I think Patreon will hang around for people who might want to just throw a couple bucks our way.

            Anyway, I’m glad to hear you’re sticking around :) I’m definitely hoping we can build LMM to the point where Andrew can dedicate all his time to it, especially since CIG takes so much of my time.

          • Roy Weber

            The fact that Thomas went into this episode blind, with no knowledge of 401(k) loans is troublesome in it’s own right. That is just as puzzling to me as the info itself. I might suggest that both Andrew and Thomas research the topic before recording. It might simply be a case of not realizing your responsibility like you guys noted above. That being said I believe that you can learn more from your mistakes than your successes. If the criticism is used correctly you can build from it. Good Luck in the future.

          • Sylvain B

            +1

          • Anthony, I hear you. I’m a chronic “bite off more than I can chew” kinda guy. I thrive in the “I’m constantly uncomfortable” realm. I expect a lot of myself.

            You also need to understand that we deeply care about creating something awesome and while the Community when you signed up was a bit rough around the edges – we didn’t paint it any other way. Between trying to create an awesome environment, code it, maintain some semblance of activity and build out the team I’ve been letting a few threads go. I’m very sorry that your experience wasn’t awesome. Email me, I’d like to try and persuade you to give us another chance – for free ;)

            As for the Patreon thing, I tried to bring people in from there into the Community for free. I felt like the response wasn’t too high but the offer still stands. I want to offer people who have contributed over there time in the Community that doesn’t involve them “paying everywhere”. The main reason I switched is I felt more comfortable providing value than asking for donations. It’s been beyond amazing that people are willing to contribute to the show getting nothing special in addition to what everyone else gets – I just want to give more.

            We’re comfortable with $10/month because we know we’re putting in many times that in value back in every month.

          • You’re very right Sylvain on all points. While avoiding PMI is important, we do have a larger responsibility.

            Publishing stuff like this is on me and while it is tough to keep the flow of interesting stuff coming while keeping up with the volume of responses from people – it’s no excuse.

            I appreciate you sticking around and while we occasionally go off into the weeds a bit, I think when we snap back on track we create better things than we were.

          • I feel like I’m a bit late to the party (on vacation right now) but I think that’s a pretty good point Thomas.

            I was excited about 401k loans because they were a great bit of easy liquidity for me and didn’t force me to sell shares in AAPL which would have been a major taxable event. That said, my situation is an edge case and going forward we need to stay away from edge cases.

            Been doing a lot of soul searching on the topics lately, I think we’ll need to reflect that mindset a bit more going forward. More focus on fundamentals and less on fluffy or edge case topics.

  • Syed H

    You guys have made a ton of great episodes that have helped me out in many areas of finances, but this one was tough to listen to. Everything I’ve read or heard about 401k loans is that they should be avoided at all costs and are only to be used as a last resort. But when I heard Andrew describe them as “awesome” and admit that he has used them (twice!), I was mildly disappointed.

    I didn’t mind the subject of the episode, but it should have come with a big fat disclaimer in capital letters that you guys do not endorse 401k loans. Because you shouldn’t. Some cursory research on 401k loans will show that they are incredibly risky and they perpetuate the behavior of finding ways to get “easy money”.

    And as a general suggestion, I think the show would flow much better if Thomas did some research beforehand. Even though you guys have done multiple real estate related shows, he did not know what PMI was. And the fact that he didn’t know that a 401k was a retirement account when the episode was about 401k loans is really weird.

    A disappointing episode, but you guys have been doing good work overall and I’m looking forward to seeing an increase in the quality of content for future episodes.

  • Andrew M

    Ok, tl;dr all the comments, points on both side. 401K is a tool, learn how it works. Should you use it? Maybe not, but it’s an option.
    I don’t believe you did anything wrong @andrewfiebert:disqus.
    Thank you @thomasfrank09:disqus for the comments.
    We do appreciate your service to the financial community.

  • Allison

    I borrowed $50k for the downpayment on our current house. We paid it back over 2 years and it allowed us to save tons of money in the big picture. No PMI and a smaller loan balance that the interest rate applies too will allow us to save thousands over the years.

    This is not something people should do often or for silly reasons. Don’t do it if you might lose your job or leave your job since you have to pay back the whole loan balance at once.

    I think a 401k loan should be your last option but it does have its place and times where it can be very useful.

  • Waiz

    Hey guys, off topic but, don’t you mean the Asahi Super Dry has a refreshing barley flavor?
    Loved the episode !!
    Cheers.