401K Loan Rules – Taxes, Interest, Pros and Cons

by Darwin on March 3, 2010

401k Loan Rules allow for easy access to retirement funds, but is that a good thing?  Many employees are unaware that they can take a loan from their 401k account for basically any personal need with very little hassle.  There are clear negative attributes to this route, but some situations may warrant considering this option, depending on the need and other options at your disposal.  One major misunderstanding is how the loan works and how it is administered.

How Much Can You Borrow From Your 401K?

Most 401k plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less. Many plans allow immediate vesting, but if not, you’ll want to ensure you understand what your vested amount is.  You usually have up to five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback.  You can basically use the funds for whatever you want.  If you adhere to the confines of these rules, you don’t need to pay the 10% early withdrawal distribution penalty since you’re paying it back within the confines of the plan.

Where Does 401K Loan Interest Go?

This is an oft-misunderstood and misrepresented question depending on which site you hit on the internet.  Based on personal experience (more on that below), the interest paid actually goes back into your own 401k account – so you’re paying it back to yourself.  You are NOT paying to the administrator, to the government or to anyone other than yourself.  You might question why there’s an interest rate at all then.  It’s basically to deter complete abuse of the provision to borrow money interest-free that was already exempted from income tax when you contributed to your account.  Suze Orman and others have also purported that borrowing from your 401K creates some sort of “double-taxation”.  While it’s a rather complex consideration of ifs, thens, and competing scenarios, perhaps it’s better stated that the interest is not tax-deductible like other options such as a HELOC, but I don’t agree that the amount borrowed is “double-taxation” by any means.  Depending on your frame of reference, one may consider the interest portion as double-taxed because you’re paying back that interest to yourself in a tax-deferred account with after tax money, and then it will be taxed in retirement – But…But – the interest portion is a marginal amount of money compared to the amount borrowed since it is often offered at below market borrowing rates.

So, let’s consider the context.  If you borrow $20,000 at 4% and pay if back over a couple years, the total interest is a few hundred dollars.  Tax on a few hundred dollars is approaching a measley $100.  Is this really worth micro-analyzing if you actually need the $20,000 for something important?  It’s less than 1% of the total amount borrowed, so it’s less than a typical annual expense ratio on many funds you’re in, or certainly less than the fees/interest on ANY conventional loan you’ll ever come across.

Where else could you borrow $20,000 for $100 and pick the payback term?

The Case FOR 401k Loans

  • It’s Your Money!  If you need it for an emergency or some compelling reason, you can stop the clock on your retirement funding, withdraw it and pay it back.
  • The interest rate is usually quite low generally at around 5% or less during the past several years. And you pay the interest back to yourself.  The net loss due to the “double taxation” of interest is marginal.
  • There is no credit check required (see why credit score is critical) and the transaction can usually executed within a week or two.  This is much faster than most other loan options.

The Case AGAINST 401k Loans

  • It’s Too Easy!  The ease of which one can withdraw the funds lends itself to bad behavior.  If people are already reckless with their personal finances by spending more than they take in by financing a lifestyle with credit card debt, what’s to stop them from drawing down the 401k in similar fashion?
  • You may miss out on a great market run.  While you’re spending that money, it could have been growing your account principal.
  • If you are unable to pay back the loan, it is considered a premature 401k plan distribution.  If you are laid off or leave your job, you may have to pay back the loan in full immediately as well.  Otherwise, you will owe federal and state income taxes in addition to the 10% penalty if you are under age 59 1/2.
  • Sporadically tapping the 401k could seriously impede your retirement goals.  Doing this under extremely rare circumstances throughout an entire career is one thing.  But taking a loan for each summer vacation and paying it back over the next year is likely to be detrimental to your long term returns.

Why Would You EVER Borrow from your 401k?

There are certain life situations that may warrant tapping your 401k account because the alternative is even less desirable.  These circumstances may include being laid off or an unforeseen medical emergency that consumed your emergency funds.  If your options are to stop paying the mortgage and face eviction, embrace payday loans, or take a 401k loan, it’s an obvious choice.  From another angle, what if a once in a lifetime investment opportunity came along?  Example – great real estate investment opportunity or a friend is selling a successful business for health reasons/retirement.  If it’s a low risk/high reward opportunity, and you’re confident you could handle the payback over time regardless of what happens to the initial funding, perhaps it’s a worthwhile endeavor.

Disclosure:  I Took Out a 401K Loan Myself

In my early 20′s, I took out a 401k loan.  I was newly employed and was getting engaged the same year I bought a house a year out of school.  I was making pretty good money for my age, as I had one of the highest paying degrees out of school and I employed sound money habits (I drove a piece of junk for years, had no other debt and all I did was work long hours).  I knew I could pay the loan back easily but I just hadn’t been working long enough to rebuild a large fund.  I had just purchased a home after all.  So, in looking at the pros and cons, I decided that rather than either a) propose to my would-be wife with a very meager stone or b) put off getting engaged/married for another year, I opted to fund a diamond I’d be proud to present with partial funding from a 401K loan.  While some may scoff at this as a “frivolous” or irresponsible use of 401K funds, I weighed the risks and given the modest amount I borrowed and the outcome, I don’t have any regrets.  As expected, I paid it back in a year, paid myself the interest, and as I recall, the market was roughly flat during the period, so I didn’t miss out on a spectacular stock market run.

When To or When NOT To is the Question

With that being said, I don’t think people should take this 401k loan option lightly.  Because it’s so easy to do, people are most certainly tempted to tap into those retirement funds for routine spending or frivolous reasons.  I mean, is tapping into the 401K any worse than carrying credit card debt?  At least with the 401K loan, the interest rate is generally 5% or under and the interest gets paid back directly to you.  With credit cards, you can pay upwards of 20% if you’re not in a 0% percent balance transfer.  Now, I’m not condoning both/either, but given the lesser of two undesirable sources of temporary income, the 401K loan isn’t looking so bad.

Do You Think It’s EVER Prudent to Take Out a 401K Loan?

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{ 16 comments… read them below or add one }

1 Evan March 3, 2010 at 11:05 am

I love your explanation of that double taxation stuff people often refer to without really understanding it. I think the reason most talking heads are against it, is because it is so easy to borrow from your 401(k) that it may be abused if the 401(k) is not made “sacred.”

One other note, these rules are not the same for IRAs which specifically prohibit borrowing by the IRS.

[Reply]

2 Budgeting in the Fun Stuff March 3, 2010 at 1:46 pm

I don’t know if I’d ever take a loan from my 401k. We have a large emergency fund, but if we needed cash, would it be better to borrow from your 401k or withdraw from your Roth IRA? I’m thinking the 401k is a better option since you pay it back…you wouldn’t be able to put money back into the Roth IRA, right?

As far as the reason you took the loan…I’m smiling but shaking my head at the same time. You had a third option; propose with a very inexpensive ring and upgrade later (like for an anniversary gift or even just after you saved enough).

BUT, it really didn’t hurt anything and made you both happy. That’s cool. That’s worth it.*

*Not that you needed my opinion. I’m just getting it in before the truly judgmental hoard take over. :-)

[Reply]

Darwin's Finance Reply:

@Budgeting in the Fun Stuff, Yes, good point on that third option. I was young and didn’t have much experience in such matters (I’ll have to do a post some day about how I bought the stone. It was quite James Bond esque). I guess in retrospect what I did worked out the best since when I bought the nice one say, now, that last one would be a sunk cost. At least it worked out – I had a very high level of confidence I could pay it off per my budget which I did. But good idea for other folks in the same boat.

[Reply]

Budgeting in the Fun Stuff Reply:

@Darwin’s Finance, Yeppers, and I would love to read about how you bought the stone! :-)

[Reply]

3 FattyR March 3, 2010 at 3:05 pm

My 401k has rather crappy investment options (a small handful of Fidelity Select funds). While I have IRA accounts that I use to diversify into other options (better international choices, REITs, commodities, etc.), I’ve maxed out the annual contributions so the vast amount of money is in the limited 401k options.

I have tossed around the idea of taking a loan out of said 401k with the sole purpose of re-investing it, for retirement purposes, in a non retirement account.

The big impact here is taxes. The funds taken out of the 401k are still pre-tax, but when reinvested in a non-retirement account, any dividends or capital gains would be taxed. So the question becomes: Do the benefits from investing in a non-401k account(diversification, better vehicles) outweigh the drawbacks of having to pay taxes on the dividends and capital gains in that account?

I’m not entirely sure how to properly answer that (and thus, haven’t pulled the trigger on a 401k loan).

[Reply]

Darwin's Finance Reply:

@FattyR, If the amount borrowed is marginal or payback period is rapid, probably a non-issue. However, if taking out say, $50K, the investment would have to have very serious benefits. i.e. non-correlated asset class, low risk, higher ROI than could be expected from stocks, etc. A real estate deal or small business might fit that bill. Taking out money to invest in say, Lending Club, would be a lousy idea.

[Reply]

4 Mike March 3, 2010 at 4:31 pm

I borrowed from my 401(k) to pay cash for an investment property from a desperate seller. I had to make a couple of payments before I financed the property and paid back the 401(k) loan. I would only recommend this if you can afford to make the loan payments for the loan term. Defaulting on a 401(k) loan results in the unpaid amount declared a distribution and that can have some nasty tax consequences.

[Reply]

5 jim March 5, 2010 at 6:43 pm

The “double tax” argument against 401k loans really annoys me. The way I’ve heard Suze Orman make that argument is that its “double” taxed because you pay the loan off with after tax funds and then you pay taxes on the withdrawals from the 401k at retirement. It makes no sense to me to look at it that way. You pay any loan off with after tax funds so its no extra taxation compared to any other loan repayment.

[Reply]

6 Ken March 5, 2010 at 8:40 pm

Let’s not forget that if you are terminated from your job a 401K loan repayment in full can be required.

[Reply]

7 Kat March 11, 2010 at 2:34 pm

Thanks for a great explanation. I was just investigating and this is the clearest description I have found of exactly what happens when you repay the loan.

[Reply]

8 Evolution Of Wealth March 12, 2010 at 3:57 pm

Jim has it right when talking about ‘double taxation’. If you put it in perspective and compare it to any other loan option you might have you pay the money back with after-tax dollars and you pay the interest with after-tax dollars. So it’s the same as any other loan.
I sort of agree with how you said it except that the full payment on the 401k loan is with after-tax dollars and not just the interest. But again, if you put it in perspective it’s the same.

The big thing that I would add is that if you take a 401k loan most 401k not only stop you from contributing but have stipulations that you might not be able to contribute for up to 6 months or a year after the loan has been paid back. This could really make those opportunity costs start adding up.

[Reply]

9 billy February 28, 2011 at 7:51 pm

At my company I have to pay my 401k loan back with after tax part of my paycheck so i will have to pay tax on that protion when I withdraw it at retirement. So it is double tax on this loan.

[Reply]

10 spunkygal April 29, 2011 at 8:05 pm

No No No…
Not getting a deduction on the loan payment is NOT the same as “double taxation.” This is why Suze Orman’s comments are so ridiculous. You already got a deduction on the funds when you put them in the 401k the first time. You think the IRS should let you take the funds out –without paying tax– and then give you a *second* deduction when you put them back in? That makes absolutely no sense. NO ONE would leave money in a 401k if that were the case.

+deductible contribution -tax free loan +after tax payback -taxable retirement withdrawal = ONE DEDUCTION & ONE TAXABLE WITHDRAWAL

+deductible contribution -tax free loan +deductible payback -taxable retirement withdrawal = TWO DEDUCTIONS & ONE TAXABLE WITHDRAWAL

The interest on the loan is the only thing you are taxed twice on. As a few have demonstrated here, it’s a mild deterent to these loans. They’re still so popular that many 401k custodians only allow hardship loans under more strict criteria.

[Reply]

11 Dana May 6, 2012 at 1:39 pm

As far as doule-taxation, I may be dense but I don’t understand these arguments. Suppose I take a $10,000 loan for 4 years and payback $50 a week.
That’s $2600 a year x 4 years = $10,400 – after taxes. When I retire and withdraw that $10,400 I’ll have to pay taxes on it. How is that not double-taxation? If I put that same$50 a week in without taking a loan that $50 only gets taxed when I withdraw it.
To say that I have to pay back any other loan with after-tax dollars or the money wasn’t taxed when I originally put it in are not valid arguments and doesn’t even pertain to the situation.

[Reply]

dave Reply:

@Dana, you need to look at the entire picture and not just those specifically taxed dollars that you are repaying your loan from. If you just looked at the money you are using to pay back the loan, yes you would be correct – those specific dollars are being double taxed . You pay taxes on them when earned. you then pay back the loan with those dollars, and if you go and take those dollars out eventually then you are being taxed again. BUT, what you are not considering is that the original loan amount you took out in itself never gets taxed if you are looking at the loan dollars and the payment dollars as separate pots of money, which is what you are doing with the ‘money I am using to pay back the loan’ part, but are not looking at with the ‘money I got from the load’ pot. for example: you have 50000 in your account. You take out a loan of 10,000. that is not taxed, and now you have a balance of 40000. now you payback the 10,000 with after tax dollars, so assuming you are in the 20% tax bracket you have now made your account ‘whole’ and have paid $2000 or so in taxes. So now you’re thinking well heck when I go to take the 50K out I am once again paying taxes on that 10,000 I put in. No, that is not correct. Why? because you have still not paid any tax on the loan amount you took out. You are forgetting that you received 10,000 and not considering that this is the amount that is being taxed when you withdraw it. If you stick with the money pot theory (I am being double taxed because I paid taxes on the money I am using to repay the loan) then you must also go with the companion ‘ I am not being taxed at all on the 10000 loan pot that I took out’..so in the end it is a wash …you are double taxed on the 10,000 pot you use to pay the loan back but you are not taxed on the 10,000 you took out via the loan…so it is a wash..you are paying taxes once on a 10,000 amount.

[Reply]

12 JB December 11, 2012 at 1:22 pm

I’m about to take a 401K loan for literally the same reason, especially with the market being unstable… ;)

[Reply]

13 SAL January 25, 2013 at 1:59 am

Do we have to report 401k loan as income on tax return? I’m planning to take out a loan and need clarification please.

[Reply]

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