Many 401(k) plans allow you to borrow $50,000 or up to 50% of funds vested in your account, whichever is less. The interest rate is likely lower than other sources, certainly credit cards.
With interest rates rising the temptation to borrow from your 401k may increase. Hey, it’s your money, why not and pay yourself interest?
- First, you technically are not borrowing from yourself, you are borrowing from the plan trust
- While nearly all plans credit the interest you pay to your account, they don’t have to
- When you withdraw money from your 401k you will pay ordinary income tax on the interest you paid yourself
- While you have the loan you are losing any investment gains if the money was in your account
- Making loan payments may cause you to lower or eliminate your 401k contributions – thus possibly losing an employer match
- If you leave your employer for any reason the loan must be repaid or the outstanding amount will be taxed, probably with a tax penalty. Your employer may require immediate repayment.
- IRS rules allow an extended period to rollover the account with the repaid loan and avoid the immediate tax and penalty. You have until the filing date for the tax year of the distribution.
The problem is in three parts:
First, many choose a withdrawal subject to both income and early withdrawal penalty taxes,
Second, many who borrow are not otherwise creditworthy, and
Third, no one should take a loan unless they need liquidity, and no one should take a plan loan unless it is superior to liquidity from any/all other sources.
So, a loan is always superior to a withdrawal, many are not otherwise creditworthy, and a plan loan is often superior to a payday advance, credit card cash advance, title loan, etc.
In fact, studies show many more Americans would improve their financial status if they used plan loans instead of other liquidity sources.
I borrowed $13K once from my 401K in the mid 1990s. But I had a chance to buy at auction the adjacent lot behind my house with a two car garage already on it so I had to take the risk. I was the only bidder since it was not a buildable lot (3-ft too narrow). I more than make up for it when I sold my house which the lot size doubled and now had a second driveway with a two car garage. The returns in my 401K actually did very well because I was paying back the loan and the market timing was extremely lucky. I must of by purely dumb luck sold high and was buying low while repaying my loan.
But I still don’t recommend borrowing from your 401K. But I like to think that I borrowed to improve an investment, not to pay off debt.
I do agree that folks who borrow to pay off credit card debt are likely to get in that trap again and shouldn’t borrow for that purpose. Way back I borrowed 50k out of my plan to pay off a lingering high interest mortgage. I did pay it off and saved some money between interest rates even though the mortgage balance wasn’t huge. It was a good move for me but if I had been younger and had less job security and a propensity to gather more debt, I would not have done the deal. So, to each his own.
I agree wholeheartedly on the 401k loans to self are almost always a bad idea. The only exception I have accepted from one of my subordinates, was when they had credit cards for $30k at 25-30% interest and were trying to get out of debt. To me it made sense to borrow that money, pay off the cards, pay only 3% +\- to the plan. But destroy the cards and not repeat the problem…. In this particular case it worked to help that couple get out of serious debt. They paid off the Loan in 2 yrs and today are living a debt free (except mtge ) life….
The borrower must use after-tax dollars to repay the loan, including interest. This means the government taxes it twice—income tax is paid on the amount again when the borrower taps the account in retirement.
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I agree. I had an employee who did that, but unfortunately again built up the credit card debt and the cycle started over.