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I'm really clueless about these loans. Who gets the interest? Does the account fund the loan, or are they simply used as collateral? What are the tax implications?

  • FYI...don't be fooled into thinking that 401K loans are better than other loans because you are paying yourself interest. Interest is interest regardless of who it is paid to. If you would have not taken out a 401K loan then the money in your 401K account could have grown by investing in some fixed income investments. Instead, by taking out a loan, you've stopped generating income with the money and must now earn more money to repay the principal AND interest. – Muro Aug 4 '11 at 17:27
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    So if my borrowing alternatives charge above market rates of return, you think it's a good idea? From a purely net worth perspective, I think your point about interest is flatly wrong. The money you pay interest with remains yours if you don't take out the loan, and is an expense if in normal loans; it seems like an mandate to move that money to your retirement account. I'm not clear yet on the point about opportunity cost. It sounds right, but only if you have to move them out and I'm unclear on whether that's mandatory. – jldugger Aug 4 '11 at 17:58
  • If you were really tricky, this seems like a loophole in the max contribution to the 401k. In a down or flat market, you could take out the loan, pay the interest and principal and end up with more money than you started with. Although I guess if you know the market is going to be flat or down, you could trade your 401k in such a way to profit from that. – Michael Pryor Aug 4 '11 at 19:38
  • One point that you might want to check on is whether your 401k plan permits regular contributions to the 401k while a loan is outstanding. – Dilip Sarwate May 7 '12 at 14:11
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Some basics. Note that not all plans operate the same way, check with your plan to find out the specifics.

  • When you take out the loan and pay interest, you are effectively paying yourself interest. It goes back into the account.
  • You can typically get a loan of only a % of your account balance - your vested balance, not necessarily the total balance. And it tops out at 50K or 50%, whichever is the smaller.
  • If you lose your job with the employer the plan is with/move company, typically you are on the hook to pay it all back immediately.
  • You may end up paying taxes twice.
  • There may be origination fees.
  • You will have to agree to a payback schedule as with a regular loan.
  • Loans for house purchases tend to follow different rules - the payback schedule is typically longer.
  • Such loans are not reported to credit reporting agencies.
  • Loans aren't available from all plans. It's at the discretion of the plan to do so or not.
  • If you're under 59 years of age you'll be slugged with a penalty tax on top of the other taxes.
  • One 401k program I was in forbid you to prepay a part of the loan. If you owed 3K, you could payoff the 3k loan, but you couldn't give them an extra 1k. Weird rule for a loan. – Alex B Aug 4 '11 at 16:08
  • Prepayment penalties are not unheard of. Without it, the risk of interest rate change falls entirely on the lender. If rates go up, they're stuck with the low rate. If rates go down, you pay it off and they have to lend at the new market low. – jldugger Aug 6 '11 at 15:25
  • @jldugger - But you are your own lender. The risk of changing interest rates falls on yourself. – Greg Feb 14 '12 at 22:31
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    What penalty tax is there? I understand that if you fail to repay the loan that it is treated as a withdraw and therefore incurs a penalty tax. But I haven't read about there being a penalty tax outside of that. – Greg Feb 14 '12 at 22:41
  • IRS rules require that repayment of a 401k loan must be in substantially equal amounts, the amounts must be paid at least quarterly, and a maximum term of 5 years (unless the money is used to buy a house). Most employers set up the repayments as a payroll deduction whose amount is specified when the loan is approved. You do pay taxes twice on the money loaned since the repayments are from post-tax dollars and the money will be taxed again when withdrawn after retirement (for regular nonRoth 401Ks). – Dilip Sarwate May 7 '12 at 2:29
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You need to check with the 401(k) administrator. Years ago, my company plan loans were taken from the short term fund, the fund that was billed as having a short duration, made up of these loans and sub-3yr government securities. This was the best of both worlds as the loan didn't impact my own returns and was still very competitive on rates.
Now, it comes from my own funds. And the interest I pay goes into my account.

The risk most often cited is that if you became unemployed, the loan becomes due. I wrote Fixing the 401(k) Loan as I believe this issue is easily resolved if congress wishes. For many, there's a choice of whether they can create a well-funded emergency account (6 months or more of living expenses) or to properly fund their retirement.

The above noted, for most plans, you borrow your own money. The tax consequences only apply if you are unemployed and can't repay the money. I walk the fine line between appreciating the risk inherent in these loans, and their prudent use in getting one ahead in their financial goals.

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