How do loans against 401k / 403b accounts work?

Question

I'm really clueless about these loans. Who gets the interest? Does the account fund the loan, or are they simply used as collateral? What are the tax implications?

Answer 1

Some basics. Note that not all plans operate the same way, check with your plan to find out the specifics.

• When you take out the loan and pay interest, you are effectively paying yourself interest. It goes back into the account.
• You can typically get a loan of only a % of your account balance - your vested balance, not necessarily the total balance. And it tops out at 50K or 50%, whichever is the smaller.
• If you lose your job with the employer the plan is with/move company, typically you are on the hook to pay it all back immediately.
• You may end up paying taxes twice.
• There may be origination fees.
• You will have to agree to a payback schedule as with a regular loan.
• Loans for house purchases tend to follow different rules - the payback schedule is typically longer.
• Such loans are not reported to credit reporting agencies.
• Loans aren't available from all plans. It's at the discretion of the plan to do so or not.
• If you're under 59 years of age you'll be slugged with a penalty tax on top of the other taxes.

Answer 2

You need to check with the 401(k) administrator. Years ago, my company plan loans were taken from the short term fund, the fund that was billed as having a short duration, made up of these loans and sub-3yr government securities. This was the best of both worlds as the loan didn't impact my own returns and was still very competitive on rates.
Now, it comes from my own funds. And the interest I pay goes into my account.

The risk most often cited is that if you became unemployed, the loan becomes due. I wrote Fixing the 401(k) Loan as I believe this issue is easily resolved if congress wishes. For many, there's a choice of whether they can create a well-funded emergency account (6 months or more of living expenses) or to properly fund their retirement.

The above noted, for most plans, you borrow your own money. The tax consequences only apply if you are unemployed and can't repay the money. I walk the fine line between appreciating the risk inherent in these loans, and their prudent use in getting one ahead in their financial goals.