Michael on April 23rd, 2008
Bookmark and Share

A 401(k) loan is different from a distribution because a loan means you intend to pay the money back to your account. In essence, you borrow from yourself. Here’s how it works, subject to additional restrictions and criteria possibly added by your employer:

  • You request a loan from your plan.
  • Typically, the loan amount cannot exceed the lesser of either 50 percent of your vested balance or $50,000.
  • You must pay back the loan in 5 years or less (unless you are using the loan to buy a house, in which case the term of the loan can be much longer).
  • You must pay interest.

You: Doesn’t seem so bad—I’m paying the interest to myself, right?
So smooth. A 401(k) loan isn’t terrible, but it isn’t desirable either. Most often, the loan is preferable to an outright pre-retirement distribution. You don’t pay taxes and penalties and, yes, you pay interest to yourself. But there are negative repercussions to consider before borrowing from your 401(k) plan:

  • During the time your money is on loan, it doesn’t grow. The amount borrowed is temporarily gone, and since it doesn’t exist it can’t grow.
  • If you do not pay back your loan, it becomes a distribution subject to taxes and penalties.
  • Your loan repayments are made with after-tax money. In other words, you use money from your net pay to repay the loan. To make a loan payment of $100 if you are in the 25 percent tax bracket, you must earn $133 of gross income. You pay $33 in income tax and the rest can be applied to the loan. Then, when you receive money from your 401(k) plan during retirement, you pay tax on that $100 again! That’s because 401(k) contributions are made with pre-tax dollars; loan repayments are made with post-tax dollars.
  • If you terminate employment with the company you work for, the entire amount of the loan is due, usually within 60 days of your last day of work. This is typically true regardless of whether you quit, are fired, or are the victim of a major layoff. Any amount you are unable to pay becomes a distribution, likely subject to taxes and penalties.

Given the length of time people stay at their jobs, don’t expect much time to pay back a loan. A 401(k) loan is a bit like playing with fire. Consider alternative sources of money and the necessity of the expense before tapping your 401(k) plan. A 401(k) plan is a retirement plan and you should use it that way.

# # #

Have you ever taken a 401(k) loan? How did it work out for you?

Bookmark and Share

4 Comments to “401(k) Loan: Friend or Foe?”

  1. George Bush says:

    I think 401k loans are fine. The alternative is to get a loan from a bank that I have to pay back to someone else with after tax dollars. When I took out a 401k loan for a car, I paid the loan back in addition to making my usual 401k contribution. The market was in a down period, so instead of losing money, I actually made more money because I had to pay back the interest, and bought more shares because the market had gone down. I was in a better place at the end of the loan than if I had not done it.

  2. Michael says:

    @ GB: I’m glad it worked out for you. Of course, the market could have just as easily gone up during the time your money was out of the market, which would have caused you to miss out on significant gains. You effectively timed the market and did so successfully. But if you (or anyone else) tried to do so 10 times, I doubt you’d be happy with the results even give times.

    The fact that you borrowed money is tangential to your successful market timing – you could have achieved an even better economic result by simply selling out of the market and putting your money in the cash option of the 401(k). But that’s just hindsight of course.

    Thanks for sharing your experience!

  3. George Bush says:

    You are right about market timing – it could just as easily have gone the other way. Had the market went up 30% during that time, I would have lost out, But I don’t believe I would have done any better with the cash option – the return on the cash option may be 4%, the interest rate charged for my loan was closer to 8%. I effectively locked in a gain of at least 8% for my money in the 401k. For long term planning, I am happy with a return of 8% in my 401k.

    Lots of pitfalls with this strategy that you mention including the potential of losing your job, or what I think many people might do, – cut back on their regular contributions so that they can pay back their loan, but if you avoid these, then I think it is a relatively decent option to borrow small amounts of money rather than taking out a non-deductible loan and pay interest to someone else.

    THanks for letting me share an alternative view.

  4. Michael says:

    Of course! Any time. Notice that the 8% is a post-tax rate and the 4% is a pre-tax rate. In addition, the possible 4% you could have earned from investing in cash doesn’t come from your paycheck; it comes from the bank. On the other hand, the 8% “return” from your loan isn’t really a return; it’s really a payment by you to you. You haven’t earned any money this way (other than not having to pay the interest to borrow similar money from a bank.)

Leave a Reply

You can use these tags: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>