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401k Loans
Posted on 6/5/13 at 3:22 pm
Posted on 6/5/13 at 3:22 pm
The conventional advice given in regards to taking 401k loans has mostly been to avoid it unless absolutely no other option is available.
If someone has a 401k with a $200k balance, and the investments are allocated between equity funds and bond funds, would it not be appropriate to think of a $50k 401k loan at 4% to be a part of the bond component in the allocation?
Why wouldn't borrowing from the 401k be better than borrowing from the bank?
If someone has a 401k with a $200k balance, and the investments are allocated between equity funds and bond funds, would it not be appropriate to think of a $50k 401k loan at 4% to be a part of the bond component in the allocation?
Why wouldn't borrowing from the 401k be better than borrowing from the bank?
4
Posted on 6/5/13 at 3:38 pm to tigerrocket
Pretty sure you get taxed pretty heavily on that $50k.
Posted on 6/5/13 at 3:42 pm to OnTheBrink
The loan is tax free unless you default.
Posted on 6/5/13 at 3:48 pm to tigerrocket
You may be right. Taken from some website (genxfinance.com):
quote:
The Disadvantages of a 401(k) Loan
While a 401(k) loan clearly has some advantages over traditional borrowing, let’s not forget that there are plenty of disadvantages that should have you thinking twice before borrowing from your retirement nest egg.
Don’t ignore fees. These loans usually aren’t free, and as mentioned above there is typically a loan origination fee of anywhere up to $100. In addition, there may be an annual maintenance fee. If you are borrowing $1,000 and they charge you a $75 origination fee that’s 7.5% of the loan. If there’s an additional $25 annual maintenance fee and you require three years to repay the loan you just spent another 7.5%. That $1,000 loan that seemed like a good idea actually cost you $150 in fees, or 15%.
If you default on your loan it won’t hurt your credit score, but it could be even more damaging to your finances. Defaults are treated as a distribution, which means your money is then taxed and you must also pay the 10% early withdrawal penalty if you’re under age 59.5. If you already spent the loan proceeds and wasn’t planning on having a major taxable event this could lead to big problems come April 15th.
There’s also a significant opportunity cost when taking a loan. If you pull money out of your retirement account you’re pulling money out of the market and/or safe fixed accounts as well as temporarily eliminating the tax-deferred growth that money would have otherwise been earning.
The market can also move between when you take a loan and when you repay it. If you’re unfortunate enough to take a loan while the market is at a bottom and then begins going back up you’ve done even more damage to your retirement account as you’ve cashed out some money at a low point and will be buying back in over the coming years while the market is high. Of course the opposite is also true, but this is a game you shouldn’t be playing with your nest egg.
You are also repaying part of the loan with money that has already been taxed. As you know, one of the benefits of contributing to a 401(k) is the fact that the money is invested pre-tax. When you take a loan you aren’t taxed on the proceeds, but the money used to repay the loan has already been taxed so your additional interest going into the account will effectively be taxed twice–at the time of contribution and again when eventually withdrawn from the account in retirement.
This post was edited on 6/5/13 at 3:49 pm
Posted on 6/5/13 at 3:57 pm to tigerrocket
Nope you're going to pay tax on the withdrawal, plus loan origination fees, plus interest. So you'll withdraw $60-65K to get the $50K, and you still have to pay back $60-65K with interest. This is 50 kinds of dumb, imo.
If you must borrow money, bank loan or HELOC is the way to go. Worst case scenario, if you for some reason default on the loan, you ruin your credit, and if you have no way to pay it back, you can usually settle and possibly file bankruptcy.
But if you default on a 401K loan, you have IRS problems to deal with on top of the debt you assumed by borrowing your own money. AND THEN YOU WILL BE IN A WORLD OF shite.
DON'T DO A 401K LOAN.
If you must borrow money, bank loan or HELOC is the way to go. Worst case scenario, if you for some reason default on the loan, you ruin your credit, and if you have no way to pay it back, you can usually settle and possibly file bankruptcy.
But if you default on a 401K loan, you have IRS problems to deal with on top of the debt you assumed by borrowing your own money. AND THEN YOU WILL BE IN A WORLD OF shite.
DON'T DO A 401K LOAN.
Posted on 6/5/13 at 3:58 pm to tigerrocket
Nope you're going to pay tax on the withdrawal, plus loan origination fees, plus interest. So you'll withdraw $60-65K to get the $50K, and you still have to pay back $60-65K with interest. This is 50 kinds of dumb, imo.
If you must borrow money, bank loan or HELOC is the way to go. Worst case scenario, if you for some reason default on the loan, you ruin your credit, and if you have no way to pay it back, you can usually settle and possibly file bankruptcy.
But if you default on a 401K loan, you have IRS problems to deal with on top of the debt you assumed by borrowing your own money. AND THEN YOU WILL BE IN A WORLD OF shite.
DON'T DO A 401K LOAN.
If you must borrow money, bank loan or HELOC is the way to go. Worst case scenario, if you for some reason default on the loan, you ruin your credit, and if you have no way to pay it back, you can usually settle and possibly file bankruptcy.
But if you default on a 401K loan, you have IRS problems to deal with on top of the debt you assumed by borrowing your own money. AND THEN YOU WILL BE IN A WORLD OF shite.
DON'T DO A 401K LOAN.
Posted on 6/5/13 at 4:11 pm to OnTheBrink
I believe the info you got from the website is the conventional thinking that I am questioning.
What else am I missing? These are some of my thoughts:
1. 401k loans are typically cheap to set up $50 or so. (no underwriting and typically done online)
2. Obviously a default would be bad because of taxes and penalty.
3. What opportunity cost am I losing if I am earning interest on the loan. If the rate is 4% or more it will be a bond like return. We shouldn't assume that 100% of one's 401k is invested in the market.
4. You are paying the money back with after tax money, but you got 50k tax free. You will have to pay the bank back with after tax money on their loan.
5. Another advantage of the 401k loan vs the bank is that it doesn't go on your credit report.
6. One of my best investments in my 401k in 2008 was my 401k loan.
What else am I missing? These are some of my thoughts:
1. 401k loans are typically cheap to set up $50 or so. (no underwriting and typically done online)
2. Obviously a default would be bad because of taxes and penalty.
3. What opportunity cost am I losing if I am earning interest on the loan. If the rate is 4% or more it will be a bond like return. We shouldn't assume that 100% of one's 401k is invested in the market.
4. You are paying the money back with after tax money, but you got 50k tax free. You will have to pay the bank back with after tax money on their loan.
5. Another advantage of the 401k loan vs the bank is that it doesn't go on your credit report.
6. One of my best investments in my 401k in 2008 was my 401k loan.
Posted on 6/5/13 at 4:11 pm to Vols&Shaft83
wrong
Posted on 6/5/13 at 4:16 pm to tigerrocket
Nope
Posted on 6/5/13 at 4:18 pm to Vols&Shaft83
401k loans are not taxable unless you default.
Posted on 6/5/13 at 4:39 pm to tigerrocket
quote:
401k loans are not taxable unless you default.
The money you repay the loan with is post-tax money.
Posted on 6/5/13 at 4:43 pm to foshizzle
But, if I borrow money from the bank, I am paying it back with post tax money, and the interest is earned by the bank not the 401k.
Posted on 6/5/13 at 4:49 pm to tigerrocket
I think it all depends on your 401k plan. In some plans, when you borrow money, the money you borrow comes out of your plan and you aren't earning dividends on the money. In my plan, you just borrow against the money in the plan and you still get to earn dividends on it. All the interest you pay goes back into the plan as well. I don't think it's as bad a deal as some make it out to be.
Posted on 6/5/13 at 4:54 pm to JonTheTigerFan
I think some of the older plans were like you describe. Even if they pull the funds out of the account, you still earn the interest from the loan rather than the bank. (so technically your 50k loan is an investment that earns interest as you pay the loan back).
Posted on 6/5/13 at 5:57 pm to Vols&Shaft83
quote:
Nope you're going to pay tax on the withdrawal, plus loan origination fees, plus interest. So you'll withdraw $60-65K to get the $50K, and you still have to pay back $60-65K with interest. This is 50 kinds of dumb, imo.
If you must borrow money, bank loan or HELOC is the way to go. Worst case scenario, if you for some reason default on the loan, you ruin your credit, and if you have no way to pay it back, you can usually settle and possibly file bankruptcy.
But if you default on a 401K loan, you have IRS problems to deal with on top of the debt you assumed by borrowing your own money. AND THEN YOU WILL BE IN A WORLD OF shite.
DON'T DO A 401K LOAN.
You're wrong.
I borrowed against mine a few years ago:
- The loan amount wasn't removed from my account so I continued to earn dividens on it.
- I paid a $25 origination fee and a 3.75% APR
- A default doesn't show up on your credit. You are just issued a 1099 by your loan administrator for early disbursement.
Posted on 6/5/13 at 6:12 pm to Golfer
My mistake, there's no tax unless you default on the loan (or in most plans, if you quit your job, you have to pay the note in full within 30-60 days). But a bank loan default DOES show up on your credit, as I said. A 401K Default may not show up on your credit, but the tax and penalty consequences can be even worse as I said. Good article on this subject
8 Reasons to never borrow from your 401K
1. You Are Not Saving
If you borrow money from your 401(k) plan, most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't have this provision, it is unlikely that you can afford to make future contributions in addition to servicing the loan payment. Because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.
2. You Are Losing Money
If you not are not making contributions, not only is the entire balance that you borrowed missing out on any potential growth in the stock or bond markets, but each future contribution that you are unable to make (since you have a loan outstanding) isn't growing either. The extraordinarily low interest rate that you are paying to yourself with your loan payment is likely to be a pittance in terms of return on investment when compared to the market appreciation that you are missing. Of course, there's also the fact that you are paying yourself back with after-tax money. If you are in the 25% tax bracket, earning $1 only gives you $0.75 toward repaying the loan, and that $0.75 will be taxed again when you retire and withdraw if from your plan. While the interest rate on the loan may be low, you are getting taken to the cleaners by its tax implications.
3. Time Will Work Against You
Long-term investing (such as saving for retirement) is based on the idea that, by putting time to work on your behalf, your money will grow. Most calculations suggest that your money will double, on average, every eight years. 401(k) plans permit each loan to be held for up to five years or longer. Therefore, if the loan is used to fund a first-time home purchase, loan holders not only lose out on what should have been an opportunity to nearly double their money, but they are also left unable to make up for the lost contribution and growth opportunities. Over time, their balance is unlikely to ever reach the total that it would have reached had contributions continued uninterrupted. (For more insight, check out Delay In Savings Raises Payments Later On, Understanding The Time Value Of Money and Why is retirement easier to afford if you start early?)
Which penny stock will turn your $1k to $10k?
4. If Your Financial Situation Deteriorates, You Could Lose Even More Money
Should you find yourself in a position where you are unable to repay the loan, it is treated as a withdrawal and the outstanding loan balance will be subject to current income taxes in addition to a 10% early withdrawal penalty if you are under age 59.5. (For more on this, read Tough Times … Should You Disturb Your Qualified Plan's Assets?)
5. You Are Trapped
If you have an outstanding loan, most plans require that the loan be immediately repaid if you quit your job. So, as long as you have a loan, you are stuck in your current job and may be forced to pass up a better opportunity should one come along, unless you are willing to take the loan balance as a withdrawal and pay the 10% penalty, which further compounds the growth opportunities that you have missed by taking the loan.
6. You Lose Your Cushion
Taking a loan from your 401(k) plan should only be done in the direst of circumstances, after you have completely exhausted all other potential sources of funding. If you take money from your plan to fund a vacation or pay off higher interest loans, the money won't be there to borrow if you really need it.
7. It Suggests That You Are Living Beyond Your Means
The need to borrow from your savings is a red flag - a warning that you are living beyond your means. When you can't find any other way to fund your lifestyle than by taking money from your future, it's time for a serious re-evaluation of your spending habits. What purchase could possibly be so important that you are willing to put your future in jeopardy and go into debt in order to get it? (For more insight, see Digging Out Of Personal Debt and The Beauty Of Budgeting.)
8. It Violates The Golden Rule of Personal Finance
"Pay yourself first" is the golden rule of personal finance. Violating that rule is never a good idea.
8 Reasons to never borrow from your 401K
1. You Are Not Saving
If you borrow money from your 401(k) plan, most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't have this provision, it is unlikely that you can afford to make future contributions in addition to servicing the loan payment. Because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.
2. You Are Losing Money
If you not are not making contributions, not only is the entire balance that you borrowed missing out on any potential growth in the stock or bond markets, but each future contribution that you are unable to make (since you have a loan outstanding) isn't growing either. The extraordinarily low interest rate that you are paying to yourself with your loan payment is likely to be a pittance in terms of return on investment when compared to the market appreciation that you are missing. Of course, there's also the fact that you are paying yourself back with after-tax money. If you are in the 25% tax bracket, earning $1 only gives you $0.75 toward repaying the loan, and that $0.75 will be taxed again when you retire and withdraw if from your plan. While the interest rate on the loan may be low, you are getting taken to the cleaners by its tax implications.
3. Time Will Work Against You
Long-term investing (such as saving for retirement) is based on the idea that, by putting time to work on your behalf, your money will grow. Most calculations suggest that your money will double, on average, every eight years. 401(k) plans permit each loan to be held for up to five years or longer. Therefore, if the loan is used to fund a first-time home purchase, loan holders not only lose out on what should have been an opportunity to nearly double their money, but they are also left unable to make up for the lost contribution and growth opportunities. Over time, their balance is unlikely to ever reach the total that it would have reached had contributions continued uninterrupted. (For more insight, check out Delay In Savings Raises Payments Later On, Understanding The Time Value Of Money and Why is retirement easier to afford if you start early?)
Which penny stock will turn your $1k to $10k?
4. If Your Financial Situation Deteriorates, You Could Lose Even More Money
Should you find yourself in a position where you are unable to repay the loan, it is treated as a withdrawal and the outstanding loan balance will be subject to current income taxes in addition to a 10% early withdrawal penalty if you are under age 59.5. (For more on this, read Tough Times … Should You Disturb Your Qualified Plan's Assets?)
5. You Are Trapped
If you have an outstanding loan, most plans require that the loan be immediately repaid if you quit your job. So, as long as you have a loan, you are stuck in your current job and may be forced to pass up a better opportunity should one come along, unless you are willing to take the loan balance as a withdrawal and pay the 10% penalty, which further compounds the growth opportunities that you have missed by taking the loan.
6. You Lose Your Cushion
Taking a loan from your 401(k) plan should only be done in the direst of circumstances, after you have completely exhausted all other potential sources of funding. If you take money from your plan to fund a vacation or pay off higher interest loans, the money won't be there to borrow if you really need it.
7. It Suggests That You Are Living Beyond Your Means
The need to borrow from your savings is a red flag - a warning that you are living beyond your means. When you can't find any other way to fund your lifestyle than by taking money from your future, it's time for a serious re-evaluation of your spending habits. What purchase could possibly be so important that you are willing to put your future in jeopardy and go into debt in order to get it? (For more insight, see Digging Out Of Personal Debt and The Beauty Of Budgeting.)
8. It Violates The Golden Rule of Personal Finance
"Pay yourself first" is the golden rule of personal finance. Violating that rule is never a good idea.
Posted on 6/5/13 at 6:45 pm to Vols&Shaft83
I would still rather see someone take out a 401k loan than be stuck with 18 % interest on credit card or make late payments and fck up credit rating.
Posted on 6/5/13 at 7:05 pm to Vols&Shaft83
quote:.
If you not are not making contributions, not only is the entire balance that you borrowed missing out on any potential growth in the stock or bond markets, but each future contribution that you are unable to make (since you have a loan outstanding) isn't growing either
This isn't the case with all 401k plans. Some allow you to still realize the dividends on the amount you borrowed against. Also, just because someone takes out a loan doesn't mean they will stop contributing to the plan. That's just absurd.
Posted on 6/5/13 at 7:34 pm to tigerrocket
I don't see a problem with 401k loans. I have taken out both a 401k loan and a HELOC for what have turned out to be very successful investments, but personally I would never take out a loan against a house or portfolio for consumables (just for investments).
If you are taking out a loan for cash-generating investments, most of the parroted conventional wisdom doesn't apply. Of the ones listed in Vol's article, only #6 (losing the cushion of being able to take out a 401k loan) was really worth considering.
The concept of defaulting on a 401k loan doesn't make sense to me. My 401k loan payments were pulled directly out of each paycheck, so it wasn't a choice to pay or to pay on time. If you lose your job, your typically have to pay back the loan within a short time frame or become liable for income tax plus a 10% penalty on the amount still owed (not a default).
Before making the decision, I worked the incremental cash flows pretty hard versus alternative options. This involves breaking out the loan into its two distinct components - the 401k investment vehicle yielding x% interest, and the loan which you will owe at certain payment terms. Anyone who has not evaluated this in detail will always mention that you are "paying back the loan with post-tax money", and it is really not worth arguing because they are not going to listen or be able to process it.
To me the biggest drawback to the 401k was the big liquidity hit. My plan only allowed one 401k loan at a time with a max of $50k. Upon taking out the loan (which had a $50 origination fee), the principal plus interest payments immediately started being deducted from each paycheck. Whereas with the HELOC, I only had to pay a small interest amount each month on the outstanding balance. So scaling in the total investment (with net cash flow increasing also over the investment phase), it made more sense to scale up with the HELOC, cover with the 401k loan, then scale up the remaining investment with the HELOC. This was the optimum in terms of having the cash flow from the investment covering the HELOC/401k payments due each month.
The investment has almost completely paid out the borrowed funds out of its cash flow alone, so it made tremendous sense for me to put the 401k funds to work outside of the mutual fund options I had within the account.
If you are taking out a loan for cash-generating investments, most of the parroted conventional wisdom doesn't apply. Of the ones listed in Vol's article, only #6 (losing the cushion of being able to take out a 401k loan) was really worth considering.
The concept of defaulting on a 401k loan doesn't make sense to me. My 401k loan payments were pulled directly out of each paycheck, so it wasn't a choice to pay or to pay on time. If you lose your job, your typically have to pay back the loan within a short time frame or become liable for income tax plus a 10% penalty on the amount still owed (not a default).
Before making the decision, I worked the incremental cash flows pretty hard versus alternative options. This involves breaking out the loan into its two distinct components - the 401k investment vehicle yielding x% interest, and the loan which you will owe at certain payment terms. Anyone who has not evaluated this in detail will always mention that you are "paying back the loan with post-tax money", and it is really not worth arguing because they are not going to listen or be able to process it.
To me the biggest drawback to the 401k was the big liquidity hit. My plan only allowed one 401k loan at a time with a max of $50k. Upon taking out the loan (which had a $50 origination fee), the principal plus interest payments immediately started being deducted from each paycheck. Whereas with the HELOC, I only had to pay a small interest amount each month on the outstanding balance. So scaling in the total investment (with net cash flow increasing also over the investment phase), it made more sense to scale up with the HELOC, cover with the 401k loan, then scale up the remaining investment with the HELOC. This was the optimum in terms of having the cash flow from the investment covering the HELOC/401k payments due each month.
The investment has almost completely paid out the borrowed funds out of its cash flow alone, so it made tremendous sense for me to put the 401k funds to work outside of the mutual fund options I had within the account.
Posted on 6/5/13 at 7:48 pm to JonTheTigerFan
quote:
Also, just because someone takes out a loan doesn't mean they will stop contributing to the plan. That's just absurd.
Referring you back to this
quote:
most plans have a provision that prohibits you from making additional contributions until the loan balance is repaid. Even if your plan doesn't have this provision, it is unlikely that you can afford to make future contributions in addition to servicing the loan payment. Because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.
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