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When borrowing funds from a 401k, does the plan hold back collateral that is not earning anything while the loan was in force?

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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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