What happens if you default on a loan against your 401k?

Answer 1

In a word Don't. If you do you will have a penalty (10%) and they will treat the distribution as income (which is taxed at whatever your rate is)

But for us taking a 401k loan two years ago was really smart.

Me and my wife took out a $5000 loan from the 401k and paid off a 14% interest rate car loan.

Those mutual funds that were sold to get that $5000 are today worth $4200 (two years later)

And the amount we will save between not having to pay full coverage insurance and the interest on the car note is quite a bit of money.

Worked so well earlier this year we took out another $6000 to pay off a 16% interest rate SUV loan.

Those funds are worth $5500 now and we have saved quite a bit in interest and not having to pay for full coverage insurance on that vehicle as well.

I took out a third loan to settle a $6000 credit card for $3500 a savings of $2500 (not to mention I won't get sued)

I'm not saying that taking out 401k loans are perfect for everyone. But, we were in a lot of stupid debt. Now we have two paid off cars (and we will never finance another one ever again !!) and we have paid off all of our credit card debt.

And the only interest we pay now is to ourselves!!!

Actually the prior provided answer below is incorrect. I have left the incorrect comment below (indented) for documentation. In reality, money used to pay back a 401k loan comes in two parts just like any loan repayment (principal and interest). The principal paid back is not taxed twice. To understand this you simply have to do the follow through math on your income over the years vs. how much you paid in taxes once you finally withdraw the money. So in this example, the 14,000$ is not taxed twice. However, interest paid on the loan is considered income to the 401k and this is NEW money going into the 401k. This interest is taxed twice because it is NEW money. You pay it in after tax dollars but unlike the principal, you did not get to use untaxed dollars to offset this. So assuming the 25% tax rate stated below, the answer below is only 25% correct. This is a common mis-understanding. Only the interest paid on a 401k loan is taxed twice, not the re-paid principal. To say that the principal paid back is paid back using after tax dollars is not correct.

Here is a simple example to illustrate: assume you have 50,000$ in the bank that has been taxed. You then borrow 50,000$ from your 401k. You now have 50,000$ in the bank on which you paid taxes and 50,000$ on which you did not pay taxes. Now you change your mind and immediatlely pay off the 401k loan with 50,000$.

Hmm... did you use 50,000$ taxed or 50,000$ untaxed go pay the loan. Let us see. Before this silly (but legal) sequence of events you had 50,000$ in untaxed money in your 401k and 50,000$ of taxed money in the bank. After wards you (oh gee) had 50,000$ of untaxed money in your 401k and 50,000$ of taxed money in the bank. How about that... nothing is different. As you can see, there is no change in your tax situation at all. Principal paid back to a 401k is not taxed twice. I love the extremes of questions. They are so good at clarifying things. If you are not getting it, think about it a bit, you will. The author of the below would have us believe that we used the 50,000$ of taxed money to pay back the loan. If we follow that logic then there is still no difference since from that point of view you have simply reversed the locations of the money, not it taxed status. In the end you still have 50,000$ of untaxed money on one place and 50,000$ of taxed money in another place.

Additionally, none of this really matters. A 401k is just another money pool with a specific set of rules. The point of taking money from a 401k is to use it smarter than the 401k will. If you get more from the money you take out than you lose, then it is a good move, that is all there is to it. In evaluating a loan (OR EARLY WITHDRAWAL) from a 401k you need to do two things:

1) do the math to know what it costs you vs. what you make with the money once you get it. You want to know this even if it is not your driving factor for taking the loan (or withdrawal).

2) weigh the intangibles somehow. Borrowing from a 401k is usually done for a purpose that cannot be accommodated otherwise. Consider an example: your daughter wants to go into the medical field. Let us assume she has two choices, be a Nurse or be a Doctor. You have the money to send her to 4 year nursing school in the bank, but you need more to make her a doctor. Your 401k can provide the extra funds needed? Do you take the loan? Some people would try to figure out the extra money she makes as a Doctor vs. a Nurse into the equation in order to justify it. Others would see that in this case the finances are immaterial. The jobs of Nurse and Doctor are different and will lead to completely different life styles for your daughter. Which life do you want your daughter to live, the life of a Nurse or the life of a Doctor? If you want to give her a shot at beign a Doctor, then you take the loan. What the loan costs may be important but is secondary to your primary goal in this case.

Below is the prior incorrect answer.

This doesn't give the whole picture. Loan repayments are made with after tax dollars from your paycheck, but get deposited in the 401k as pretax money. So when you retire, you pay taxes on all that money again. In the case above, the person has taken out a total of $14,000. Estimate the interest they paid themselves and we're talking a total of approximately $18,000. That $18k was already taxed at a conservative rate of 25% for federal, state, and local taxes. That means their pretax loan payments comes to $24,000.

That's a $10,000 difference. That's a lot of money "missing". Also consider that the $18,000 that this person took as a loan has already been taxed at 25%. When they retire/quit and take their money out of their 401k, they have to pay 25% AGAIN on that money. That's another $4,500 (potentially more if they are under 59.5) they are paying to the IRS.