Borrowing from your 401(k) is generally a bad idea. There are some positive aspects of doing so, however. It’s a nice option to have if you are stuck with no other choices. Here are some of the drawbacks, as mentioned by Lewis Schiff from the Armchair Millionaire.
- The money you take out of your 401(k) for the loan will not be growing. Most people, while paying back the loan, stop making pre-tax contributions, which is a double whammy.
- Since you’re paying back the loan with after-tax money, taking distributions from that money will cause some funds to have been taxed twice.
- If you leave your job, the full amount of the loan could be due immediately.
- If you can’t pay back the loan, the unpaid balance will be treated like a distribution, meaning you’ll have to pay taxes and possibly penalty fees.
There are some benefits to being able to borrow from and pay interest back to yourself, but they do not outweigh the drawbacks.
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I don’t understand the ‘taxed twice’ point. Isn’t the initial contribution to the 401k tax-free? Now, if you did not take the loan, but used some other source of funds, that would have been after-tax money too. So, I think this double taxation whammy is bogus. From what I understand, for financially savvy people, if a loan you get is at a higher rate than the expected return in your 401k, then you take a loan from the 401k, otherwise you take an outside loan. The only relavant point is that if you lose your job, you would need to immediately pay back this loan to avoid early withdrawal penalties. Everything else just obscures the issue.
For clarification on the “taxed twice” issue… When you take out a loan from your 401(k), the money you receive has not been subject to income tax. However, when you pay back the loan, you are paying with money that has already been taxed as regular income. However, the funds replace pre-tax contributions in your 401(k). When you retire and begin taking distributions, all of the pre-tax contributions—including the money you used to pay back the loan—will be subject to tax.
I tend to agree with AKG, taxed twice sounds like mumbo jumbo to me. Show me an illustration that demonstrates your point with numbers that apply to a broad cross section of the public.
Let’s not forget why people consider a 401k loan. They need the money!! If they didn’t need it, they wouldn’t consider it. Let’s keep another thought in mind, 401k savers are no dummies. First and foremost, they are savers. In addition, they understand tax deferral, diversification, the power of compounding and they appreciate employee matching contributions. The last thing to remember is that we’re only talking about 5 years, and unless the rate spreads are significant, it won’t amount to much of a difference over that period of time.
IMO, it’s mostly a wash because if you opt between a 401k loan or the closest competitor, a Home Equity Loan, the Costs and Benefits offset one another. For example, you’ll probably get a better rate on your 401k loan than on your Home Equity Loan. The difference is more income that can be used for savings or expenses. On the other hand, depending on your marginal tax rate, the amount of tax savings favors a Home Equity Loan over a 401k Loan. When it comes down to making a decision, I recommend you do the math. Look at the terms of each option over the entire period and compare the results of taxes, income, 401k balance and most important of all, the impact on making additional financial choices.
In a declining equity and interest rate market, it wouldn’t be a bad idea to borrow from your 401k if you need funds. In retrospect, a max loan from your 401k beginning in the spring of 2000 thru 2005 would have been a great idea. How well has the market done over that same period of time, and what costs would have been born on a higher interest loan?
My conclusion, the 401k route is a good choice. It only becomes complicated when you get into unusual situations affecting the difference on spreads from the prime rate.
I don’t think the principal paid back to the 401K loan will be double taxed, but the interest that is paid into the 401K for the loan will be double-taxed. That it not mumbo jumbo. That is a fact. You pay the interest with after tax dollars, then when you retire, the interest that you paid when it is withdrawn is taxed again.
Yes, but who cares if it’s double taxed? He’s looking at the total in the 401(k) at the end, which is comparing apples and apples. It’s a nice little emotional thing, but not a factor in the final analysis. I big deal though is that I didn’t see him discuss the investment of the repaid loan in the 401(k) as time goes on, that’s a huge bonus for the 401(k).
I surprised they did not point out a potential downside of the 401(k) which is you can end up paying back every cent of the tax you saved in the first place.
Example, a relative of mine contributes $4,000 a year. They are in a 25% tax bracket. So let’s say they save about $1,000 per year in taxes. After 20 years they’ve saved $20,000 in taxes, and she gets 50 cents per dollar contributed by the employer.
So in 20 years (roughly) when she wants to retire, she’s got a good chance at having just shy of $300,000.
They might be in the same tax bracket with her husband’s income, but even if they aren’t, assuming they are in a 15% tax bracket, if they withdraw 5% of their IRA at that point, that’s $15,000 less 15% tax ($2,250) is $12,750. after 10 years they paid back everything they’ve saved in taxes. Granted their employer’s contribution ended up giving them about $100,000 of that…but then their social security benefits are taxable at I think the 50% level with that income when you include her husbands income.
And, when they pass away (assuming they don’t use all of the money) and if/when it goes to their kids, they’re kids pay $84,000 in taxes on that $300,000 plus it’s includable in their estate (which I don’t think will be a problem but still) it pretty much negates the tax benefits altogether IMO
Dave