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Avoiding the Temptation of the 401(k) Loan

In this edition of our Motley Fool Conversations series, Fool personal-finance expert Dayana Yochim and retirement-planning analyst Dan Caplinger discuss the allure of using your retirement savings as a way to borrow money for immediate expenses. Given the lengthy process and chance of rejection in getting a bank loan, as well as the high cost of alternative financing like payday loans or credit card cash advances, tapping your 401(k) can be very tempting as a quick source of cash.

Even though many 401(k) borrowers note that they're essentially paying interest to themselves, Dan points out that you have to use after-tax money to repay your loan, which amounts to paying tax twice on the same money. Moreover, if you have trouble paying the loan back, it'll be treated as an early distribution, incurring immediate tax liability and potential penalties. Worst of all, if you lose your job, you have to pay back your loan immediately or else faces dire tax consequences. For those workers for whom a 401(k) loan is truly a necessary last resort, Dayana and Dan offer some advice and useful tips to avoid getting yourself into credit trouble with a 401(k) loan.

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Comments from our Foolish Readers

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  • Report this Comment On March 13, 2013, at 12:48 PM, StopPrintinMoney wrote:

    I wouldn't be surprised if at some point in the future the govt starts borrowing from our 401k's. Don't feel bad though, they'll replace the money with IOU's (treasuries).

  • Report this Comment On March 14, 2013, at 1:08 AM, FictionalMonkey wrote:

    "Dan points out that you have to use after-tax money to repay your loan, which amounts to paying tax twice on the same money."

    I get rather tired of hearing this oft-repeated and incorrect statement.

    What you fail to state is that the "loaned" money never had taxes paid. Not when it was put into the 401k and not when it was loaned out and spent. So you have an amount that never had taxes plus an equivalent amount taxed twice, which equals out to the two equivalent amounts being taxed once each as is expected.

    Another way to put it. If you took out a loan of 5000 then this is 5000 you never paid taxes on since it was placed into the 401k pretax. You earn another 5000 to repay it, paying taxes on the 5000 used to repay and 5000 when it is eventually distributed from the 401k at retirement. You then earned a total of 10000 over this period (5000 from 401k and 5000 from take-home) and paid taxes on 10000 (5000 from 401k distribution and 5000 on take-home pay) exactly as expected. Had you not taken the loan and waited until you earned the needed 5000, you still would have earned a total of 10000 (5000 from 401k and 5000 from take-home) and paid taxes on a total of the same 10000 (5000 from 401k distribution and 5000 on take-home pay). YOU ARE NOT double taxed, but taxed exactly the same.

    What you ARE double taxed on is the INTEREST paid to yourself. The interest you pay yourself is not pretax money you took out in the loan but is truly earnings that were taxed and then taxed again at 401k distribution.

    So please, the next time you are tempted to repeat this incorrect statement, make sure you really understand what you are saying lest you provide inaccurate financial advice. The next time you here this incorrect statement, please remember that you must also do your own due diligence and understand the advice and information that others provide before making your own decision lest you end up making a (possibly tragic) misinformed decision.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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