The bottomline is a 401(k) loan to yourself makes sense in the following situation:
- You need to take out a loan anyway.
- Your only other options have an interest rate of over 3%
- The amount you can take is sufficient to cover the loan
- You can pay back the loan within the time limit
Did you know that you can use your 401(k) as an account to take a loan from? It’s true. When I first found out I did a little investigation, to see if there were any catches. Although some people advise against using your 401(k) this way, I think it’s better than taking out a loan and paying someone else a higher interest rate. So let’s take the list of pros and cons from MSN Money with my own comments:
- There is no credit check. You don’t have to apply for the loan, and you can make plans knowing that you will get the loan.
The point here is you’re using your own money. I’m a big fan of using your own money first instead of borrowing from someone else.
- There is a low interest rate. You pay the rate set by the plan, usually a couple of percentage points above the prime rate.
I’m not sure how this interest rate is decided. I know in my case, the company that manages my 401(k) has a set interest rate. Is this a legal mandate? What if I just created a personal “loan company” that would lend to me at 0% interest, issued myself shares which I bought with my 401(k) instead? Shouldn’t I be able to choose my interest rate since I’m really just “investing” my money in another vehicle?
- It provides a great return. If your money market account is earning 3% and you pay yourself back at 6% or 7%, it looks like a good deal.
Wrong. This is not an advantage. Paying yourself back an interest rate (all of which must be after-tax) is really no advantage at all. The advantage you get is that you didn’t take out the loan and pay someone else interest.
- The interest is tax-sheltered. You don’t have to pay taxes on the interest until retirement, when you take money out of the plan.
Again, see above. You already paid taxes on the interest because you’re using after-tax money. You will be taxed on the interest twice. You will be paying an extra 20 – 30% in double taxes on the interest you are putting back in! So if you are borrowing at 6% from your 401(k), it could be equivalent to borrowing from a bank at 2% because that amount will eventually go to taxes one day.
- It’s convenient. Some plans only require you to make a phone call, while others require a short loan form.
Yes, it’s convenient to use your own money. Just make sure you really want to take out the loan.
- About that credit check: Of course there isn’t one. You’re not borrowing anything. You’re spending your own money.
I really don’t see how this is a disadvantage. If you need to take out a loan, using your own money is better than using someone else’s and paying them interest.
- You’re losing interest. The net effect is that you have less money to invest and to earn interest. The money you borrow — or take out — of your retirement plan no longer appreciates in value from interest, dividends and/or capital gains in conjunction with the rest of your investment portfolio. Remember that you aren’t really borrowing. All you are doing is using money from one account, such as your checking or savings account, to repay the money you borrowed from your 401(k). And when you take money out of that checking or savings account, that money loses interest, too.
Yes, you’re losing interest on the money by virtue that you’re using it for something. Again though, this can be better than paying the interest to someone else, depending on how the market is doing. If you’re making 8% interest on your 401(k), you could be losing up to 10% effectively. So if someone else will loan you the money for 8%, it’s better to take out the loan instead.
- It’s not tax-sheltered money anymore. Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars. So, let’s say your monthly interest payment is $300 and you’re in the 28% tax bracket. You’ll have to make $416 in gross earnings to make the $300 payment. Then, when you retire and take withdrawals, you pay taxes yet again.
This is neither here nor there. The money you get from the loan is pre-tax anyway, so paying it back is equivalent, even if you’re paying it back with post-tax money. Get it? The only money you get double taxed on is the interest.
- Unless you repay the loan, it is considered a premature distribution. You would owe federal and state income taxes as well as that 10% penalty if you are under age 59 1/2.
Yes, you better make sure you pay back this loan on time or it’s a horrible deal.
- The loan isn’t tax deductible. It’s considered a consumer loan, so there is no tax advantage.
Ok, but why is this a disadvantage? All things being equal, why should we expect our loans to be tax deductible?
- It affects your psychology toward retirement saving. If possible, your retirement money should sit untouched until you retire. It’s too easy to get in the habit of dipping into your 401(k) instead of saving for things you need along the way. Keep your 401(k) in a loan free zone.
Yes, so basically if you can “do without” the loan to begin with that would be best. It is good to pretend that your savings aren’t there for use.
So overall the biggest disadvantage I can see (to those of us who know how to control our spending) is the loss of potential interest in whatever investments you have in your 401(k). That means the current economic conditions it wouldn’t be such a bad move.