While every 401(k) plan is different, most will let you borrow as much as 50% of your vested balance up to $50,000. The loan is paid back through your paycheck, with interest. Most plans have competitive interest rates and the loans can be carried for up to 5 years. If you use the proceeds of the loan to purchase a primary residence, that pay-off term may be extended.
When you are making payments back into the loan, you are paying yourself interest on the money you borrowed. This is where it gets a bit foggy. First, when you draw your paycheck, you pay taxes on the earnings. Then you pay the interest on the loan out of what remains. At a later date, say retirement, you begin drawing from the plan. Those distributions are taxable income, therefore taxed again. You are paying income taxes twice on the funds you use to pay interest on the loans. (Special tax rules apply to Roth 401(k) contributions).
There is an opportunity cost with taking a loan from your 401(k) as well. If those funds are not invested, they are not continuing to grow tax deferred. So, what is the opportunity cost? Well, you need to compare the interest you are paying yourself and the future tax implications previously discussed with the lost opportunities of tax deferred investment returns.
There are other considerations as well. For instance, if there is a separation from employment, the plan may require that the loan be immediately repaid. If you don’t have the funds to repay the loan, it is treated as a taxable distribution. If you are not age 59 Â½ or more, a 10% early withdrawal penalty may also apply to the taxable balance.
Whether or not you can afford to pay back the loan and still make contributions to the plan should be carefully considered. Would the circumstances that have lead you to look at borrowing the funds as an option impair your ability to repay the loan? If so, this might not be considered a viable option.
The interest you pay on alternative financing options may be tax deductible. For example, the interest on a home mortgage often qualifies for a tax deduction. However, the interest on a plan loan repayment often is not. Be sure to weigh the comparisons of tax deductibility for both alternatives before making a decision.
Every plan is different and will have various restrictions. Consult with your plan administrator before deciding to borrow from your 401(k).