How can I figure out the real cost of a 401K loan? | 401k Questions

Question

Asked 10/5/2006

How can I figure out the real cost of a 401K loan?

This is only for people who know about 401K and 401K loans. Kiddies, scammer, and beggars - stay out or you'll be reported.

The money that goes into 401K loan is pre-tax. Say I take out $30K as a loan at 10% for 5 years. I re-pay myself monthly, so the interest is not a big deal (I'm the bank). The problem as I see it, is that I'm repaying with 'after-tax' money. How can I figure out what the loan is actually costing me? Let's assume tax rate of 30%. I know that there are many other variables (like initial loan fee and the fact that the money that I take out is not earning interest, dividents, etc.), but just want clarification on after-tax payments for a pre-tax fund. Thanks

Answers

Answer 1/4 - Submitted 10/5/2006

You are the lender. There are no taxes.

You pay interest to yourself, into your 401K.

Your cost is the fee charged by the custodian.

One bad part is that the interest that you pay back to yourself, is after tax money. It is taxed again when you take it out after you retire. You cannot figure what the taxes will be then. But it is only on the interest, not all the money. My sister would argue this, and say it is on all the money you put in, but you didn't pay tax on the money you took out. It depends on how you view it.

Another bad part, is that you are not making gains on that money for the duration of the loan.

Another bad part, is that if you quit or lose your job, you have to pay it back right away.

Answer 2/4 - Submitted 10/6/2006

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Answer 3/4 - Submitted 10/6/2006

You are correct. You used after tax money to paying back the loan. Your tax rate will determine the extra amount you will add back to 401k.
by using your example, 30k/60month=500/month+10% interest=550. in reality, you add 30% more of your tax rate
550+165=715 is your actual amount you paying back the loan

Answer 4/4 - Submitted 10/6/2006

There are two issues here. First, your impression about 'after-tax' money is not correct. Any type of loan (including a bank loan) is paid back using 'after-tax' money.

http://p075.ezboard.com/f401khelpforumsfrm6.showMe ssage?topicID=205.topic

A major exception is mortgage loan, whose interest payment is tax deductible. Other types of loans are not deductible. You can thank Reagan's tax reform (1984) for that.

Second, you should calculate the present value (PV) if you really want to know the opportunity cost of money. MS Excel has some financial functions, but you are probably better off investing in a $15 financial calculator. If you haven't already, you should learn to use it before taking out any non-401k loan. You don't have to pull it out on the loan officer; you will be in a much better position just knowing what is going on.

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