We discussed the key benefits of 401(k) loan in last blog post, now we will discuss the downsides of borrowing from 401(k).
Not Truly Cost Free
Despite the view that net cost is zero, the true cost of a 401(k) loan is the foregone growth on the account — and not the 401(k) loan interest rate, which is really just a transfer into the account of money the borrower already had, and not a cost of the loan — the best way to evaluate a potential 401(k) loan is to compare not the 401(k) loan interest rate to available alternatives, but the 401(k) account’s growth rate to available borrowing alternatives.
For example, if you borrowed $10,000 from your 401(k), paying 5% interest back. It looks like the $10,000 part of your 401(k) account grows by 5%, however, it is just you are moving the $500 money from one pocket (outside of 401k) to another pocket (inside your 401k).
Tax Implications
Furthermore, the interest contributed into the 401(k) plan isn’t deductible as interest, nor is it deductible as a contribution — even though once inside the plan, it will be taxed again when it is ultimately distributed.
Of course, any money that gets invested will eventually be taxed when it grows. But in the case of 401(k) loan interest paid to yourself, not only will the future growth of those loan payments be taxed, but the loan payments themselves will be taxed — even though those dollar amounts would have been principal if simply held outside the 401(k) plan and invested.
Viewed another way, if the saver actually has the available cash to contribute to the 401(k) plan, it would be better to not contribute it in the form of 401(k) loan interest, and instead contribute it as an actual, fully deductible 401(k) plan contribution instead. This would allow the individual to save even more, thanks to the tax savings generated by the 401(k) contribution itself.
Missed Employer Match
Finally, a 401(k) loan borrower may miss the employer 401(k) contribution match which will be a real cost.
Not Truly Cost Free
Despite the view that net cost is zero, the true cost of a 401(k) loan is the foregone growth on the account — and not the 401(k) loan interest rate, which is really just a transfer into the account of money the borrower already had, and not a cost of the loan — the best way to evaluate a potential 401(k) loan is to compare not the 401(k) loan interest rate to available alternatives, but the 401(k) account’s growth rate to available borrowing alternatives.
For example, if you borrowed $10,000 from your 401(k), paying 5% interest back. It looks like the $10,000 part of your 401(k) account grows by 5%, however, it is just you are moving the $500 money from one pocket (outside of 401k) to another pocket (inside your 401k).
Tax Implications
Furthermore, the interest contributed into the 401(k) plan isn’t deductible as interest, nor is it deductible as a contribution — even though once inside the plan, it will be taxed again when it is ultimately distributed.
Of course, any money that gets invested will eventually be taxed when it grows. But in the case of 401(k) loan interest paid to yourself, not only will the future growth of those loan payments be taxed, but the loan payments themselves will be taxed — even though those dollar amounts would have been principal if simply held outside the 401(k) plan and invested.
Viewed another way, if the saver actually has the available cash to contribute to the 401(k) plan, it would be better to not contribute it in the form of 401(k) loan interest, and instead contribute it as an actual, fully deductible 401(k) plan contribution instead. This would allow the individual to save even more, thanks to the tax savings generated by the 401(k) contribution itself.
Missed Employer Match
Finally, a 401(k) loan borrower may miss the employer 401(k) contribution match which will be a real cost.
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