People are often mystified by the mechanism of borrowing money from a 401K.  Many experts advise against borrowing as a rule.  I generally agree, but like anything in life there are exceptions to the rule.  Still, I think people are often confused about both the drawbacks and advantages of borrowing.

Advantages

  • Interest is paid to yourself, however the interest is a market rate (currently 9% in my 401k which was as low as 5% a few years ago)
  • No need to qualify for loan

Disadvantages

  • After Tax Dollars used to pay interest will be taxed again
  • Wastes Tax Deferral Advantage
  • Balance of the loan is due upon job severance

I think the part that confuses most people is the after tax nature of the loan payments, and how tax deferral works.  Loan payments made to the 401K come from after tax dollars, and as a result are taxed again at withdrawal.  However given that no taxes are due when the loan is made, effectively only the interest payments into the loan are doubly taxed.   The principal payments are matched in amount by the “tax free” loan.  For example let’s say I had 10,000 in my 401k, and borrowed all 10,000 with a 10% interest rate for 1 year.  I do nothing with the 10,000, and the next year I pay back the entire amount with interest, $11,000.  The $1000 in interest is coming from after tax dollars and required $1250 in pretax dollars (assuming a 20% income tax bracket), but the $10,000 in principal is funded by what I took as a loan.  Now let’s say I decide to retire the next year and withdrawal the money, I will owe $2200 in taxes on the full $11,000 balance. Had I decided not to borrow against my 401k, and was able to achieve a 10% return independently, I would still have owed $2200 in taxes on the full balance. Where I’m paying extra taxes is the $250 I already paid to make my interest payment.

Tax deferral is the biggest benefit for 401k plans.  By borrowing against the 401k, you’re giving up the ability to grow money annually free of taxes.  Let’s say for example I were to borrow money from the 401k to put into investments outside of the 401k.  We also assume these investments are identical to what is in my 401k.  In my 401k, the 10,000 I borrowed would’ve grown to $11,000 after a year assuming a 10% return.  In my taxable account the money only grows to $10,800 because I need to pay taxes on it during the year.   As a result, every year taxes act as drag on my investment reducing what’s available for reinvestment.  There is no such drag within the 401k.

Though as with many things related to taxes,  the actual outcomes can be more complicated.   Capital gains (gains made by buying at one price and selling at a higher price) verus income (which includes interest payments) are taxed at different rates.  In addition capital gains are not payable until sale which is in effect a form of tax deferral.  In theory it’s possible to actually lower the total tax bill by borrowing against the 401k and converting what be taxable as regular income into longer term capital gains which are taxed at a lower rate.   However for most people in most situations, borrowing against the 401k will increase the total taxes that ends up getting paid.