mattcardwell.com

Is it a good idea to take a loan from your 401(k)? In my opinion, it is usually not an ideal source from which to borrow money. Some will argue that a retirement plan loan is one of the best kinds of loans because with a retirement plan loan, your repayments are actually paying yourself interest instead of a bank or other lender. While this is true, the retirement loan itself is a bit of a gamble.

In most cases, when you take a loan from your retirement account, you are essentially taking a significant chunk of money out of your retirement account all at once and repaying it back in small pieces over a number of years. The wager you are making – whether you realize it or not – is that the interest you pay to yourself throughout the repayment schedule will be greater than the earnings you would have made on your investments had you not taken the loan and, instead, left the money invested in your account. In a market that is declining or in a market that is relatively flat throughout the life of your loan, the interest you pay to yourself in the form of loan repayments will likely be higher than the earnings you would have made had the money remained invested. In this case, your gamble will have paid off. In an up market, however, the interest you pay to yourself in the form of loan repayments is likely to be lower, sometimes much lower, than the earnings you would have made had the money remained invested. And due to compound interest, that situation can be detrimental to your retirement account accumulations in the long run.  It is important to mention that the interest you pay on a retirement plan loan is also not tax deductible in the way that your home mortgage interest or the interest you pay on a home equity line of credit is tax deductible.

Retirement accounts such as 401(k) and 403(b) plans are what is known as “tax-deferred accounts”. This means that all of the contributions you make to these plans are not taxed as income to you in the year in which you make the contributions. On top of that, you are not taxed on any of the earnings you make on those contributions as long as you leave them invested in the account. This is a really good deal for you. Once you retire, however, the IRS is going to get its hands on as much of that money as they can. In other words, when you withdraw money from your retirement account to fund your expenses in retirement, the IRS is going to tax you on that money using income taxes – the same way they tax you when you draw a salary from your employer.

All of that to say that when you take a loan from your retirement account, you are withdrawing money that was sheltered from income tax in your retirement account. When you make repayments on the loan, you are repaying the loan with money from your checking account that you have likely already been taxed upon as salary or income from your job. So, in essence, the money that you put back into your retirement account as a loan repayment will already have been taxed once. Where this really hurts you is when you decide to withdraw money from your retirement account to fund your expenses in retirement. The portion of the money that you withdraw from your account that was used to repay your loan will be subject to income tax again. In other words, that money has been subjected to double taxation because you were already taxed on the money you used from your checking account to repay the loan and then you were taxed again on those same dollars again as you withdrew them from your retirement account.  Why in the world would you subject your money to income taxation more than once?