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 investor 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:
- 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.
- The ‘interest’ you’re paying yourself isn’t tax deductible because it isn’t really interest.
- The IRS doesn’t look at the 5 percent as a contribution. Since it isn’t a contribution, it isn’t tax deductible.
- 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.