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I was looking at some information about my 401(k) and noticed that it's possible to take out a loan from your 401(k) - it was something like 6.5% interest, which probably isn't as good as a conventional loan/mortgage...

But if the 6.5% interest is going back into my 401(k), that's vastly better than it going to the bank, right? So who does the interest go to from a loan against a 401(k)? My 401(k)? Or somewhere else?

  • You get the interest in your 401k. This isn't an exact dup, but it's close, and certainly related: money.stackexchange.com/q/80853/17718 – TTT Feb 13 '18 at 15:27
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    In some ways I think the correct answer is: the IRS. They get about 35% of your loan balance at the time of the inevitable. – Pete B. Feb 14 '18 at 13:16
  • No one really *gets* interest. – Möoz Feb 15 '18 at 4:04
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The "interest" just goes back into your 401(k), but there's also an opportunity cost. You miss out on any gains that the money would have earned if you had not borrowed it, so from a cash flow standpoint the interest is 6.5% - meaning you pay it back as if it were a loan at 6.5% - but from a wealth standpoint the cost could be higher, depending on how long you take the loan out for.

Also, note that if you leave your job (voluntarily or involuntarily), the entire remaining balance will be due immediately, otherwise it will be treated as a distribution and subject to income tax and a 10% penalty. Plus, you might be forced to decline better employment opportunities since you would have to pay the loan back.

Generally 401(k) loans are considered too risky considering the opportunity cost and the possibility of getting hit with a tax bill.

  • What if the loan amount is your asset allocation to fixed income within your entire retirement plan? – user662852 Feb 13 '18 at 15:45
  • Then your expected opportunity cost will less, but there is still a cost. Also note the other risks I have added to my answer. – D Stanley Feb 13 '18 at 17:07
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There are some plans with a provision that if a 401(k) loan is outstanding, you cannot make new deposits, only payments to the loan. This would keep you from getting any matched funds, potentially giving an effective rate on the loan into the 100%'s. e.g. you borrow $10K for 5 years. You lose $5K/yr in matching, every year the loan is outstanding.

Aside from the above, ask 2 questions, separately.

  • Would I be happy with a 6.5% return on my 401(k)?
  • Does a loan at 6.5% make me better off? i.e. can I borrow at 6.5% and put the money to good use? I'm thinking paying off the credit card bill that's running 24% for the balance of your daughter's kidney transplant.

If both of the above are "yes", you just need to consider the risk that if you lost you job or even changed jobs, the loan needs to be paid back.

My informed opinion is that one 'fix' that 401(k) accounts need is the ability to maintain a loan post employment. It's awful to consider that one might be offered a better job, higher pay, but realize they are tied to an outstanding loan and would have to jump through hoops to raise funds to pay it back, transfer the 401(k) to new employer, then take out new loan. A transfer of the 401(k) with the loan in tact should be an option.

Similarly, if one lost their job, the payback is just an extra burden. The loan should remain, and the administrator assess a small fee for processing it outside the normal payroll deduction. Very small fee.

And, yes, the answer to the question title, is that the interest charged goes back to you.

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    Interesting - I had not heard about that provision. So your opportunity cost jumps to 100%+ in that case. – D Stanley Feb 13 '18 at 17:08
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    "Some", that's key, and anecdotal. I read it here (another question) as an objection to my mentioning the 401(k) loan. – JoeTaxpayer Feb 13 '18 at 17:10
  • Odd. When I left my last employer I was allowed to keep making the usual payments on the loan. I did not transfer my 401k until the loan was paid though – Eric Feb 14 '18 at 4:49
  • There are many cases that are "permitted, not required." My semi-rant above promotes that keeping the loan after job separation should be a required (i.e company must offer) choice offered to the employee. – JoeTaxpayer Feb 14 '18 at 14:55
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An additional consideration

A major risk is that you leave your job or your employer makes a major change to their plan. I worked at a company where several of my friends had 401k loans and had to pay the full amount back immediately because our company was part of an acquisition and they closed out our old 401k plan.

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Yes, it goes back into your 401(k), and you can think of it as the "earnings" from the "investment" of loaning money to you.

Whether that's "better" or "worse" than borrowing the same amount from a bank and then investing your 401(k) money in other ways is a matter of opinion. By loaning that money to yourself, it's not otherwise being invested in some other investment that could be earning a higher rate of return than the 401(k) interest rate; but on the other hand, it's guaranteed to earn that rate of return with no "risk", which you can't say for most investments.

Note that, like all loans, you would have paid tax on the interest more times than you get to keep. Like all loans, you get the money after-tax (you don't need to pay tax on getting the money), and you pay the money back, including the interest, with after-tax money, so you would have paid income tax once on the interest that you don't get to keep. Although in a 401(k) loan the interest is paid into the 401(k), it is treated like any other investment "earnings" in the 401(k) that will need to be taxed when you take it out if it's a Traditional 401(k). (Some people like to say you get taxed "twice" on the money; but it's really just a combination of getting taxed "once" on interest you don't get to keep as a borrower, plus getting taxed "once" on earnings you get to keep once as a lender, so it's no different than any loan you get from a bank, except you're the lender.)

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The interest from a 401k loan goes into your 401k -- you are borrowing the money from yourself: Source

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