Borrowing from your 401(k) can be expensive in a way that you may not have thought of. In my June 9th Article I wrote about some of the good and bad characteristics of 401(k) loans. However, there is a not so obvious cost in the loan that you should be aware of.
As you may know, 401(k)s are funded with pre-tax dollars. This is great because you delay paying income tax on your contributions until you start taking money out of your 401(k) account. To be clear, a loan is not a distribution. So, you do not pay income tax on a loan…sort of. Here is an example of what can happen. Let’s assume your marginal tax rate (MTR) is 25%.
- Over time, you’ve contributed $10,000 to your 401(k) in pretax dollars.
- You decide to borrow $1000, maybe you want a new TV
- There’s probably a loan origination fee, maybe $50
- Loan interest rate may be a little high, but you’re paying it to yourself…~5%
- You pay back the loan over a one year term. Including interest, you’ll have to pay back $1028. Unfortunately, you do it with post-tax dollars. With an MTR of 25%, you’ll have to earn $1371 to pay back the original $1000.
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