The 401(k) Loan: Friend or Foe for Clients?

Borrowing from a 401(k) plan can prove to be a taboo subject that some clients are reluctant to consider even if the circumstances require that a loan otherwise be obtained from an outside source.  A client’s hesitation to raid his or her 401(k) nest egg in order to fund other life events is understandable—these hard-earned funds are supposed to be earmarked to provide income during a long and well-deserved retirement. 

Despite this, there are many scenarios where a client will be obligated to borrow funds in order to finance major purchases or unanticipated emergency expenses. While a 401(k) plan loan will not always be the best option, in some cases such a loan can actually help a client come out ahead—if the circumstances are correct.

Why Consider a 401(k) Loan?

A 401(k) plan is not required to provide for plan loans—and even if the plan does, the value of the loan cannot exceed

1. the greater of $10,000 or 50% of the account balance or
2. $50,000, whichever is less. 

While 401(k) loans generally have a bad reputation, for a financially responsible client who has a short-term need for additional funds (note that 401(k) loans generally must be repaid within five years), a 401(k) loan can provide an appealing option.

Many individuals who take out 401(k) loans do so in order to finance a real estate investment. For example, it may be beneficial for a client to borrow against his or her 401(k) in a situation where he or she is buying and selling a home at the same time. The 401(k) loan can be used as a bridge to pay expenses related to the new home until the proceeds from the sale of the old home are received—eliminating the necessity of obtaining additional bank financing.

Other clients may consider 401(k) loans as short-term college tuition financing options—rather than making payments ratably throughout the school year, the loan can cover the costs of tuition up front (often at a discounted rate). This can be an attractive option if the client is able to repay the loan throughout the same school year (repayments are generally made via payroll deduction).

For many clients who have unforeseen expenses, or wish to finance a large purchase, a 401(k) loan may be attractive because no credit check is required (as would be with a traditional bank loan) and interest rates may be more favorable than other options. Further, the loan will not impact a client’s credit rating and can usually be obtained fairly quickly. However, the client should carefully consider the objections discussed below before using the 401(k) loan option.

Objections to a 401(k) Loan

Importantly, the client should consider his or her ability to repay the loan balance within a short time frame while continuing to make contributions to the 401(k). Generally, the loan balance must be repaid within five years and payments must be made at least quarterly (special rules apply in the case of a 401(k) loan taken out to finance the client’s principal residence).