401k loan

Posts you want to find years later go here.
Post Reply
Peijen
Minion to the Exalted Pooh-Bah
Posts: 2790
Joined: Fri Jul 18, 2003 2:28 pm
Location: Irvine, CA

401k loan

Post by Peijen »

401k Loan Interest Expense
Even though you’re borrowing from yourself, you still have to pay interest! Most plans set the standard interest rate at prime plus an additional one or two percent. The benefit is two-fold: 1.) unlike interest paid to a bank, you will eventually get this money back in the form of qualified disbursements at or near retirement, and 2.) the interest you pay back into your 401k plan is tax-sheltered
Did that said what I think it said? you get the interest back when you retire and you can deduced the interest from tax?

Sounds too good to be true, because the only thing you are losing out on is compounded interest you would've saved with that interest, but if you are taking out a loan for whatever you have to pay that interest anyway.

Jonathan
Grand Pooh-Bah
Posts: 6722
Joined: Tue Sep 19, 2006 8:45 pm
Location: Portland, OR
Contact:

Post by Jonathan »

I think it says the income you earn on the interest you pay yourself is not taxed, not that it is a tax deduction.

George
Veteran Doodler
Posts: 1267
Joined: Sun Jul 18, 2004 12:26 am
Location: Arlington, VA

Post by George »

401ks are tax deferred, not tax free. So, the returns on investments paid for by your interest payments would not be taxed now at your current rate, but rather when you retire and begin to extract money from the plan.

I wasn't aware that the interest is payed into your balance. I assumed that the plan administrators pocketed it. The concept of paying interest to yourself for the privilige of borrowing assets you already own makes no sense. As a bank fee, it does, but if it doesn't go to a third party, why require it at all? Why not simply require a repayment schedule?

I also thought I heard that you lose all returns for the investments you borrow against until you pay them off.

But I can't cite a source for either.

quantus
Tenth Dan Procrastinator
Posts: 4891
Joined: Fri Jul 18, 2003 3:09 am
Location: San Jose, CA

Post by quantus »

Exactly as you said, your 401k is meant as a retirement account, it grows at a compounded rate every year and is tax sheltered until you start to draw on it at retirement. As such, the government is counting on collecting taxes on the amount you contribute and all the compound interest gained. You are not meant to take tax sheltered money away from it and rob the government of potential tax revenue from the interest you've essentially just stolen from the final balance of the account. By paying yourself interest, you are paying yourself the interest that it would've earned had you left it alone in the account and the final taxable amount remains roughly the same. The likely reason they index it off of the prime rate rather than the actual performance of your plan is to limit the variability of the rate you have to pay yourself yet still insure a reasonable amount is repaid and becomes taxable. The government wants its money at some point and doesn't want money to come out while never being taxed.

You do lose the returns for the investments that you borrow because they've been liquidated from the account. As I already explained, I think that's why you pay yourself interest.

Note, I agree with Jonathan. I don't think that the interest being tax-sheltered means that you can deduct it. Rather, I think it just means that the interest will get to grow tax-sheltered like the rest of the 401k and it doesn't have to be handled specially.

Now, is it better to pay a lower interest rate to someone else or a higher interest rate to yourself? Depends on if you can afford the purchase at the higher interest rate. If not, you're stuck.

Interestingly, if your 401k was sucking and not growing or shrinking. It might've been actually good to take the money out, buy a house and actually be making some money in your 401k even though your beating the market by subsidizing the gain yourself. I don't recommend this though since there's likely to be a fund you can put your money in that outperforms the prime rate. If your company sucks so much that a plan is not available, change jobs because your company probably won't survive.
Have you clicked today? Check status, then: People, Jobs or Roads

Post Reply