You can borrow money from yourself and pay yourself interest. What is this and why is this a good thing?

If you work, you’re likely to have an employer-sponsored retirement plan. For those who work in the private sector, it is the “401(k)”. It’s your own money but you cannot access it without penalty and tax consequences until you’re 59.5 years old. So basically, it’s like the money you cannot touch.

But, you can borrow from it by taking out a loan using your 401(k) as the lender. You can

  1. borrow as much as 50% of the total vested balance, or $50,000, whichever is lower, from your 401(k) account;
  2. set up a repayment schedule, from up to 5 years for regular loan and longer for purchase of primary residence;
  3. pay yourself back plus interest via paycheck deduction.

Depending on your 401(k) provider, the fee to initiate such a loan is mostly lower than obtaining a personal loan, the interest is lower and does not tie to your credit worthiness, and most importantly, it will not reflect on your credit report. Some providers also allow flexible pre-payment. Thus, it is a low-cost way as a short-term loan or bridge loan.

However, there are certain considerations. First, you will sell your investment during the loan period, which may reduce the future growth of your retirement account. This may not be a big issue if the intended period is short.

Second, you will pay interest from your post-tax dollars and put into a pre-tax account. Thus, the interest amount is subject to double taxation on 401(k) distribution. Again, this is not an issue when the loan period is short.

Third, for those who have Roth or after-tax 401(k) contributions, your situation is more complicated. You should discuss with your 401(k) provider to see whether the loan should be deducted from your pre-tax or post-tax portion or in a pro-rata form. Again, the impact is smaller when the loan period is short.

To conclude, 401(k) loan is a low-cost and convenient way to obtain a short-period bridge loan, such as between selling your current home and purchasing your new home, between your yearly bonus and big-item shopping, etc.

Disclaimer: This is information I gathered during my own research on this topic. It does not constitute financial or tax advice and it may not be applicable to your situation. Consult a financial advisor or tax professional for questions.