The Big Downside of 401k Loans No One Talks About
There's a big downside to taking out a 401k loan that no one talks about: taxes. If you read an article about the pros and cons of 401k loans, the usual list of cons includes: not being able to make contributions to the plan while you have a loan; losing out on the growth your loan money would have enjoyed if it had stayed in the 401k account; and if you lose your job (quit, change jobs, get fired) while you have a loan outstanding, the remaining loan balance is typically due within 60 days.
Those are all good reasons to think twice before taking out a 401k loan. But the biggest reason to really avoid these loans, if at all possible, is the tax treatment. When you repay your 401k loan, you do so with after-tax dollars. Remember that normal contributions to a 401k are made with pre-tax dollars, which is one of the major benefits of participating in a 401k plan. But loan repayments are made with after-tax dollars, so there is no tax break there.
What's worse though, is that when you eventually retire and begin withdrawing money from your 401k in retirement, all of your 401k money--regular contributions and loan repayments--is taxed as ordinary income. That means your loan repayments will be taxed twice: first at repayment while you're working, and once again at retirement. That double income taxation makes 401k loans very expensive!
Now the typical argument made for taking out a 401k loan is that the interest rate is very reasonable, and in essence, you are paying yourself that money. After all, it was your money to begin with, and you are simply borrowing from yourself. While the interest rate may indeed be a great deal, the tax treatment is anything but.
Before you decide to take out a loan from your 401k, be sure to consider how income taxes will affect your total borrowing costs. In many cases, double income taxation will make the loan cost ineffective. It's pretty rare to find double taxation in the tax code (at least for individual taxpayers). And the reason simply has to do with fairness to the taxpayer. Unfortunately, 401k loans get unfair tax treatment under current tax law. And that often makes them a bad deal for retirement savers.