This may be a stupid nieve question regarding my 401k ?

Question

I recently left my job for a new better paying & better future one. Looking over my options as to what to do with my 401k that will now sit there couldn't help but laugh at the thought of paying interest on my own money that I would be loaning myself. While I would never take a lump sum or even a loan against my 401k no matter what I couldn't help but laugh at the idea of borrowing from myself paying a fee to do so & then paying someone else interest on my own money that I loaned myself not their money they loaned me. I also of course would be hit with possible taxes. I can understand the tax issues for taking a lump sum or even a loan but why do you have to pay someone else interest on your own money? I get companies charge a fee thats only fair but if your borrowing basically your own money why do you pay interest on it & on top of that why does it go to someone else even though its not their money your borrowing from? Again I get the fee & the possible tax issues but the interest & that going to someone else for you own money thats crazy. I would never do it just had to ask how come you pay interest to someone else for borrowing your own money especially if its all vested?

Answer 1

Because you are getting tax advantages by putting money in your 401k--it reduces your taxable income.  And to get those advantages the money is supposed to be kept growing, separately, until your retirement.  There's a lot of paperwork, recordkeeping involved, whenever you mess with your 401k.  So contribute the maximum amount permitted, and leave it set until you retire.  You get free matching money from your employer you don't get if you don't contribute and you make your retirement more secure.

Answer 2

First, it's not your money.  401k contributions made by the employee are called deferrals for a reason.  You are "deferring" receipt of the money until a future date (thus the tax deduction).   But in answer to your question...when taking a loan you do not pay someone else interest.  Any interest that you pay is credited to your account.   You pay interest because the trust is loaning you money.  They must act in the best interest of the plan as a whole and to a lesser extent you as an individual.  Loaning money without charging interest doesn't do either.  Lastly, there are no tax  issues with taking a loan unless you fail to repay it but even then it ceases to be a loan and instead becomes a distribution and thus becomes taxable.

Answer 3

Borrowing from a 401(k) is not wise, but not for the reason you state.  When you pay interest on a 401(k) loan, the interest goes into your 401(k).  In other words, you are paying interest to yourself.

What makes borrowing from a 401(k) a bad financial decision is that the money you pay back (including the interest) has already been taxed.  You then pay it back to the 401(k) where it stays until you withdraw it during retirement, at which time it will be taxed AGAIN.  So when you take a loan from a 401(k), you are essentially volunteering for double taxation.

Answer 4

The 401K (and the IRS) is trying to make this a level playing field decision for you.

If you borrowed money from a bank, you would have paid interest, so they charge interest as well.

Otherwise, it's not a loan, but a distribution and fully taxable.