Many 401k plans offer loans. Check with your plan. It may be one of the features.
Today we’ll take a look at how 401k loans work so each of us can decide whether it is a good financial decision to borrow from our plan.
Interest
For all of us that have had home or car loans, or even credit cards, we are familiar with interest. Interest is the money we pay to a lender for the privilege of borrowing.
As much as borrowers hate interest payments, think about if the shoe were on the other foot. If I came to you and asked to borrow $1,000, assuming you had the funds available, you’d want something in return.
You’d want to be compensated for handing over that money. Plus you might want additional compensation to offset the risk that I could miss a payment or that I may default on the loan. Lenders are in business to make money. They provide a valuable service (how would we ever buy a home without them?) but they need to be compensated.
No Interest Loan
How cool would it be to get a no interest loan?
If I go to a bank, I’ll pay hundreds or even thousands in interest. If I borrow from my 401k, I make interest payments to myself. Yup, that’s right. I pay myself interest. Essentially an interest free loan.
Here’s How It Works
I go to my HR department and say I’d like to take a $50,000 401k loan to help buy a home. Plan rules and requirements vary, but work with me…
I fill out a bunch of paperwork and in a short period of time I have a check for $50,000.
Important point: I am borrowing from my 401k, not against it. My 401k is selling investments to raise cash and giving me a check for the cash value. If my 401k balance before the loan was $100,000, after the loan it is $50,000.
This is different than borrowing against something. We could take a home equity loan in which we’re borrowing against our home, or we could take a margin loan from our broker in which we are taking a loan against our brokerage account assets.
In these 2 cases, a lender is loaning us money and using the asset – our home or our brokerage balance – as collateral.
So, with the 401k loan, I’m borrowing my own money, and I’m paying principal and interest back into my 401k. So I’m basically paying myself.
Why That Stinks
It sounds great.
But let’s take a deeper look to see why this may not be ideal.
When I borrow $50,000, my 401k administrator is selling assets and handing me a check for $50,000. My $100,000 account balance now becomes $50,000.
Remember compounding? What compounds faster? 100k or 50k?
And if you read the part about a penny doubling, it’s clear that once we reach higher dollar values, compounding has an exponential effect.
So what happens when we take money out of our 401k, which is supposed to be a compounding machine to build wealth over 40 years or more? Yup, compounding takes a big hit.
Taxes
We also have a tax hit with our loan repayments.
We receive our check for $50,000.
Now, beginning with our next paycheck, our payroll provider will start taking loan repayments out of our paycheck. Let’s say the loan repayment, principal and interest, comes to $500.
The good news here is that $500 repayment goes right back into our 401k, and will be invested according to our instructions. So after our first payment, we may now have $100,500. That’s cool, the money can start compounding again.
But the repayment is made after-tax. Our payroll provider takes taxes out of that money before setting aside the $500 for repayment. This essentially means we are being taxed twice.
Let’s look at an example:
- That $100,000 in our 401k went in before taxes. It came out of our paycheck before we paid any tax (though some of that could be earnings on our contributions – but still, not taxed)
- The $100,000 loan came out with no taxes. So far so good.
- My $500 per paycheck loan repayment goes in after taxes. So if I’m at a 15% tax rate, I had to earn $575, have the $75 withheld for taxes so that $500 could go to my 401k loan repayment.
- When I retire, I’ll take out my 401k money and I’ll pay ordinary income tax rates for all the money in the account.
I got taxed twice on the loan repayments.
Leaving Your Job?
Often if we decide to leave our job, we’ll need to pay back the loan in full.
If leaving is a possibility, we need to make sure we have a plan to repay the loan.
If we can’t repay, this becomes a distribution which will be taxable in full and will likely have a penalty as well.
Wrap Up
Loan interest is a killer. Having the ability to pay the interest to ourselves seems like a great idea.
But we need to keep in mind that foregoing the compounding in our 401k could prevent us from reaching our retirement goals,
And we’ll be paying more in taxes on each loan repayment.
And to be completely honest, I took a 401k loan to buy my first home. At that time, I didn’t understand the full implications. But, at that time, I’m not sure I had other options.
It’s important that we understand how 401k loans work so we can evaluate our options and make a decision that works for each of us.