Financial Planning

401(k) Loans – Are You Really Paying Yourself Interest?

When someone is looking at lending options, occasionally their 401(k) is one of them. Why wouldn’t you take a loan from your 401(k); you’re technically paying yourself interest, right? Unfortunately, it’s not that straightforward.

In most cases, an investors can distribute money from their 401(k) as a loan. The loan value can be up to 50 percent of the account value or $50,000, whichever is less. The loan must be paid back within five years and there must be a reasonable interest rate attached to the loan, usually prime plus 1 or 2 percent.

So far, it sounds like a rather good option. However, there are a few key points you should understand:

  1. You aren’t actually earning interest. You’re just making an additional 5 percent contribution with dollars from outside the plan, e.g. your savings account. The ‘interest’ is no different than increasing your 401(k) contributions.

  2. The ‘interest’ you’re paying yourself isn’t tax deductible because it isn’t really interest.

  3. The IRS doesn’t look at the 5 percent as a contribution. Since it isn’t a contribution, it isn’t tax deductible.

  4. Here’s the worst part. The ‘interest’ you’re paying yourself has already been taxed and will be taxed again when you make distributions at some point in the future.

In some cases, a 401k loan may be your best, or only, option. Just don’t kid yourself with it being a great deal because you get to pay yourself interest.