Question:
When borrowing funds from a 401k, does the plan hold back collateral that is not earning anything while the loan was in force?
Coaches response:
Yes, the vast majority of 401k loans work like that. If you have 100k and take a 25k loan, the 25k that is used as collateral will be moved into an interest-bearing account until the loan is paid back. This could be good if the underlying investments would have lost value in a down market (lije 2022 to date). It could be bad if the underlying investments would have increased in value in an up market.
A few other points:
- 401k loans are capped at the lesser of 50k or 50% of the account balance
- The only way to pay back loans is via payroll deduction contributions
- if you change employers, an outstanding loan balance would be taxable as income plus 10% penalty unless the new employer's 401k allows for rollovers with loans, which is rare.
In short, a loan interrupts the growth potential of the money and has a variety of “gotchas” in the details. Not an ideal strategy for access to capital prior to retirement.
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