Is a Roth 401(k) loan a free lunch vs. a pretax 401(k) loan?

Submitted by Dan Simonds on Thu, 2023-02-23 02:15

If a plan allows a participant to select the source of a 401(k) loan, is borrowing from the Roth 401(k) account a free lunch vs. borrowing from the pretax account? Since loan repayments are with after-tax dollars, paying those to the Roth (where they could grow and later be distributed income tax-free) seems to be a long-term advantage vs. paying after-tax loan payments into a pretax account, since all retirement distributions from the pretax account will be taxable income. I’m assuming the loan interest rate paid will be similar to the investment return within the 401(k).

Does anyone agree or disagree that Roth 401(k) loans have an advantage over borrowing from the pretax account?



Submitted by David Mertz on Thu, 2023-02-23 12:47

  • “Since loan repayments are with after-tax dollars, …”
  • As a general statement, that’s a false statement.  Only interest on the loan is necessarily paid with after-tax dollars.  The loan principal is paid back from the loan principal; money is fungible.  This means that the principal of a loan that came from a traditional 401(k) account that contained only pre-tax funds is paid back with pre-tax funds (because it was pre-tax funds that were loaned to you).
  • The difference with a loan from the designated Roth account is that the interest paid goes into the designated Roth account to become investment gains in the designated Roth account rather than investment gains in the traditional account.  When interest payments go to the designated Roth account, taxes will only be paid once on the interest provided the requirements for qualified distributions are been met.

Submitted by Dan Simonds on Thu, 2023-02-23 21:18

Thank you DMx. Your explanation clarifies the question, and I now see it’s essentially a wash between pre-tax vs. Roth as the loan source. Maybe the only advantage to borrowing from the Roth would be if the loan interest rate meaningfully exceeded the return on what the assets, if not borrowed, would have earned in the Roth. No free lunch, again!

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