If your employer has a 401(k) plan, the plan likely has a provision that allows you to borrow from the plan. Although the plan will charge you interest on the amount borrowed, the repayment of the interest and amount borrowed go back into your 401(k) plan. So regardless of the rate of interest charged, whether it is 3% or 5%, isn’t your net cost of borrowing zero because you are paying yourself? Doesn’t it sound like an interest-free loan?
If it were truly an interest-free loan, would it not make sense to borrow as much as possible from your 401(k) plan? After all, if the plan charges a 5% interest rate, where in today’s market can you earn 5% guaranteed? Should you borrow the max from your 401(k) plan to maximize your financial wealth?
The misconception about these plans is that the borrower is coming out ahead. In reality, that is not the case. The person paying the interest (you) is the same person receiving the interest (you), thus the net interest paid to you is really a zero rate of return. These payments of interest and principal are merely transfers between accounts you own.
When you borrow from your 401(k) plan, the plan very likely prohibits you from making any contributions to the plan until the loan is repaid in full. Thus the tax deferred growth and employer matching contributions are lost which means that you have suffered an opportunity cost for making the loan.
An additional caveat about borrowing from a 401(k) plan is that if your employment is terminated or you leave your employer for another opportunity, many plans have a provision that require that the loan balance be paid immediately. Since you likely borrowed from the plan because of the need for cash, it is unlikely that you will have the cash to repay the loan. Failure to pay the loan will result in a deemed taxable distribution to you which will result in an increased income tax liability. If under age 59 ½, you will also be subject to the 10% early withdrawal penalty.
With respect to maximizing your financial wealth, if you are fortunate to have an employer 401(k) plan, you should consider contributing an amount at least equal to the employer match dollars as this is “free” money.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.