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