I am planning on taking a 401K loan - is it true the interest paid is returned to my 401K account?

Question

I seems like a good loan to take as long as it is paid back in the alloted time and doesn't go into default. Any other considerations?

Answer 1

If you take a 401K loan it is true that the interest you pay goes back into the account. Generally the interest rate is around 5%. The lengths of the loans vary but is usually a 10 year process. When you contribute to a 401K the contributions are all taken pre-tax so there is a benefit in lowering your taxable income. When you pay the loan back, the payments are taken after tax so there is not much benefit. If you earn more than 5% interest in your 401K(most people earned at least 12% last year), it is probably not a good idea to take a 401K loan as you will be losing potential interest on your investment. Another thing to consider is changing employment after the loan is taken. If you leave your company you will have to pay the loan back immediately or you will pay severe penalties for the disbursement unless you are 59 1/2 years old.

Answer 2

This is a VERY BAD idea. If you get laid off or quit your job before it is paid off, you have 30 days to pay the whole balance or suffer the same taxes & penalties as an early withdrawal! Also, you cannot make extra payments on it if you decide to pay it off early. You have to save up the whole balance & pay it at once or jsut let it get paid back a paycheck at a time. Furthermore, from an employer/acctng dept perspective, it makes you look like you can't manage your money well. Finally, most of these loans pay off over a long period even if the amt is small. Ex: a $1000 loan amortized over 5 yrs. It's just foolish. You end up paying yourself 5% interest instead of leaving that money alone to earn 12% in a good mutual fund.

Get a second job for a short time instead, have a yard sale or sell some stuff on ebay. You might learn something new & you won't be in debt when you're finished spending the $$.

Answer 3

Yes, you get the interest, so you're paying interest to yourself.

However remember that your 401K is earning interest too-- so you have to figure that if you are paying 10% on the loan and your 401K has a history of earning 6%, you're only paying yourself 4% and the other 6% is the true cost of the loan to you.

Also if something happens, like you lose your job, the full amount may be due immediately or you risk the penalty fees normally asssessed with a 401K withdrawal.

Answer 4

I don't know where people come up wiht this 5% figure. Interest on a loan has to be at or very near market rates. Most plans use prime +2% which means right now about 10%. So the differential between what you would earn in your account and what you pay yourself in interest is relatively low and y our account won't be hurt that bad. Beware of a 5 year loan though. Rarely do people stay with an employer more than 5 years...if you leave, you'll have to get your new employer to accept the loan or you'll have to take the distribution which means taxable income to you and you kill your retirement.

It's a last resort thing...done properly it will work out. But if you leave your job then it's pointless to have done it...just means you have to work an extra year or two before retirement.

Answer 5

I believe that it true, however, you don't gain the benefit of compound interest that you would if you left your money in the 401k. For example, if you have $10,000 in your 401k and you get a loan for $5,000, there is only $5,000 remaining in the 401k to gain you money. This $5,000 earns interest. The interest it earns will also eventually earn interest.

If you take a loan, you lose that earning power of the compounding interest, instead only paying yourself back a flat interest rate. In borrowing from your 401k, you also take a large tax penalty which further diminishes the return you are getting.

Unless an absolute must, I would highly recommend against this.

Answer 6

No, it won't be taxed. But if you leave the company before you pay off the loan, you can have a tax problem. If the company makes you rollover the 401k, you have to either take the tax hit, or pay the loan back right away (which could be difficult if you were just laid-off).

Answer 7

What are you using the loan for?

Dipping into the 401k is one of those things that should be last resort. Most have rules against it. Money from there will cost you quite a bit in future earnings. It needs to stay in place in order for it to be of any use.

I once heard that you should only borrow money in order to make wealth. A lot of people do not do this these days. Getting a house is a good thing to use a 401k loan for but if you could find another way, I would advice finding another way.

Answer 8

Yes that is how it is paid back.

Other considerations, will your investments perform better than the interest rates on the loan?

Is that the only source of loan or would another loan provider be a better source? (home equity loan, student loan).

If you leave your job, it may all come due at once.

Answer 9

Yes it's true that you pay the interest back to yourself. In certain cirmcumstances you can qualify for a hardship disbursement- medical emergency, house purchase, child's educational expenses, among several others. You don't have to pay that back- you can, and have 3 years to do so, but if you don't pay it back, you'd need to pay taxes on the disbursement, but can do that over the 3 years instead of all at once ( I did this once and it worked well for me. I increased my contributions % afterwards to help offset the disbursement).

Answer 10

It is a good idea because you are basically paying back yourself with interest. It would be a good idea to have the payments taken out of your paycheck, that way you don't even miss the money and you won't default.