Author Topic: A Few Thoughts on Borrowing Against the 401k  (Read 4556 times)

randersonnw

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A Few Thoughts on Borrowing Against the 401k
« on: December 10, 2014, 02:17:42 AM »
I have been thinking about this for a bit and had to put it out there. Originally I was wondering if it's possible to borrow from the 401k for anything, I believe it is, for example a home or investment property. Then my thoughts and research led me to think about how effective it might be to borrow from the 401k (assuming it is heavily weighted towards stocks) during a period where you felt the market was getting expensive and paying it back as the price comes back down. Question: do you have to make regular, read monthly, payments or just have it paid back w/ interest w/in the five year window?
I am newly contributing and planning on maxing out my contributions and wanted to get some opinions about the possibility and effectiveness of using these savings in an interesting (tax free ) manner on a future down payment.
The part about borrowing to time the market was an aside, but struck me as interesting. Thanks guys and gals!

randersonnw

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #1 on: December 10, 2014, 02:31:52 AM »
Found this and answered most of my questions. Good info for newbs like me. 

http://www.investopedia.com/articles/retirement/03/070203.asp

surfhb

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #2 on: December 10, 2014, 03:09:08 AM »
I have been thinking about this for a bit and had to put it out there. Originally I was wondering if it's possible to borrow from the 401k for anything, I believe it is, for example a home or investment property. Then my thoughts and research led me to think about how effective it might be to borrow from the 401k (assuming it is heavily weighted towards stocks) during a period where you felt the market was getting expensive and paying it back as the price comes back down. Question: do you have to make regular, read monthly, payments or just have it paid back w/ interest w/in the five year window?
I am newly contributing and planning on maxing out my contributions and wanted to get some opinions about the possibility and effectiveness of using these savings in an interesting (tax free ) manner on a future down payment.
The part about borrowing to time the market was an aside, but struck me as interesting. Thanks guys and gals!

Do you have a crystal ball?   Why do you feel the market is expensive?   Can you be assured you will retain your your job in another crash?   Most 401k loans are payable right after your terminated..... Which basically means you will lose alot.    :).   

It's not a good idea :)

ken

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #3 on: December 10, 2014, 06:07:44 AM »
As SURFSB said, this has 'bad idea' written all over. It is based on the idea that you know which way the market will go, that means market timing, which mos successful investors know is in the bad idea column. Even the article you posted says 'sometimes it may be necessary to borrow from a 401K..' It does not go on to say it is a good idea.

Your post says you are just getting started with investing and hope to max your 401K contributions. Keep your focus on saving and eliminating unnecessary expenses. Don't be studying about ways to time the market.


shawster

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #4 on: December 10, 2014, 08:16:05 AM »
The other downside is that after you take out a loan from your 401k, you might be tempted to reduce your contributions to pay off the loan and would lose the company match. So if you take out a loan and your employer is matching 50% of your contributions, and you reduce your contributions to make ends meet, you are missing out on those employer matching funds until the loan is repaid. For me, that's a huge and unacceptable loss for me. Payday loans, which are terrible, have a lower opportunity cost to me than borrowing from my 401k for this reason.
If you are absolutely dead-set on timing the market-which I can never seem to do, move your money into cash instead of completely out of the 401k.
Add to that, the repayment is not tax-advantaged, like a home-equity loan, there are origination fees and you have a big risk if you are laid-off and must repay within 60 days.
« Last Edit: December 10, 2014, 08:23:05 AM by shawster »

Cheddar Stacker

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #5 on: December 10, 2014, 08:57:43 AM »
@ randersonnw, they are not for everyone, but you are here and you know better than 99% of consumers. So far I haven't seen any support in this thread for 401k loans, and I'm not surprised. Many people don't understand or trust them.

I've posted this list on the forum a couple times before, but it's worth posting again so people can understand what they're getting into. This is not all doom and gloom guys. These can be a very powerful tool, but just like a chainsaw, you have to know how to use it.

401k loan Pros:
Interest is around 4-5%, plus maybe $25-50/year fee, so they are cheap.
Interest is paid to yourself within the 401k, not paid to a bank, so you keep all the money.
It acts as a bond in your 401k (fixed interest, guaranteed return on investment).
You don't have to get approval from a bank.

401k loan Cons:
If you get fired/quit you have to either pay it back in full or withdraw the outstanding balance (So don't do this if you plan to get another job soon, or aren't in a stable job situation).
You can only take out the lesser of $50k or 50% of your 401k balance.
It takes away from your other 401k investments pool, so there's an opportunity cost since that money isn't invested.
You pay it back with post-tax money (you do this for all debt, but it feels different here as a paycheck W/H so worth mentioning).
You might not be able to contribute to the 401k while the loan is outstanding (I was able to when I took out a loan for an investment, all plans are different).

To answer your specific question, yes you have to make regular payments to repay the loan. However, if you are 6 months into repayment and you want to clear the loan, you can make a payment to do so.

I've taken a 401k loan for a very specific investment purpose, and it worked out great. I repaid it within 18 months. I have an extremely stable job and was not worried about that aspect at all. I have a partner who took one out during a house repair rather than wait on the insurance company to write him a check for the damages.

Market timing - this is no different than changing your stock/bond allocation. Life circumstances change, economic outlooks change, no need to skewer someone for changing the risk they are willing to take in the market. A 401K loan will just increase your "fixed income" exposure in your portfolio.

Wile E. Coyote

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #6 on: December 10, 2014, 10:04:08 AM »
Yes, of course there are risks involved and doing this just to time the market wouldn't be wise, but there can be very valid reasons for borrowing against your 401(k), and sometimes you also happen to get lucky (not a reason to do it, of course). I have done it twice, and it has worked out quite well.

And yes, I did do it at a time when I thought the market had gone up quite a bit in a very short amount of time.  That's not the reason I did it, but it made it easier to pull the trigger because i was very happy with the gains and was content to put some money to work elsewhere for the time being and DCA back in as the loan was repaid over the next year.   The main reason I did it was to refinance my very non-mustachian mortgage loan. Rates had dropped tremendously, and I wanted to take advantage of that. Unfortunately the conforming loan limits had also dropped, so in order to refinance into a conforming loan and get the lowest rate, I had to pay down a significant amount of principal. Rather than sell investments out of my taxable account and trigger gains, I decided to borrow against my 401(k).   The rate drop was very substantial, and given the size of my mortgage it was very worth it.  The second time was a similar scenario when rates had dropped again and the conforming loan limit had dropped again, so basically the same scenario. Both times I happened to get lucky with market timing as the market dropped shortly after each loan (not advocating this as it was complete luck and could just as easily have gone the other way), but of course that was gravy. I would have ended up in the same boat with market timing in my taxable account, but would have triggered taxable gains.

YMMV
« Last Edit: December 10, 2014, 10:05:58 AM by Wile E. Coyote »

frugalnacho

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #7 on: December 10, 2014, 11:32:47 AM »
If you thought equities were over priced and wanted to cash out so you could cash back in when they are lower...why don't you just change your asset allocation inside your 401k?  Wouldn't it be much easier to just move your entire allocation into bonds, then after the crash when stocks are cheap, move them back into stocks? 

I don't advocate market timing, nor do I think you could be successful using this strategy, but wouldn't that be easier than taking a loan out and then repaying it?

Wile E. Coyote

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #8 on: December 10, 2014, 06:50:58 PM »
If you thought equities were over priced and wanted to cash out so you could cash back in when they are lower...why don't you just change your asset allocation inside your 401k?  Wouldn't it be much easier to just move your entire allocation into bonds, then after the crash when stocks are cheap, move them back into stocks? 

I don't advocate market timing, nor do I think you could be successful using this strategy, but wouldn't that be easier than taking a loan out and then repaying it?

OP mentioned using the cash for a down payment on a home or investment property.

frugalnacho

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #9 on: December 11, 2014, 06:23:27 AM »
If you thought equities were over priced and wanted to cash out so you could cash back in when they are lower...why don't you just change your asset allocation inside your 401k?  Wouldn't it be much easier to just move your entire allocation into bonds, then after the crash when stocks are cheap, move them back into stocks? 

I don't advocate market timing, nor do I think you could be successful using this strategy, but wouldn't that be easier than taking a loan out and then repaying it?

OP mentioned using the cash for a down payment on a home or investment property.

Then his next sentence was:

Then my thoughts and research led me to think about how effective it might be to borrow from the 401k (assuming it is heavily weighted towards stocks) during a period where you felt the market was getting expensive and paying it back as the price comes back down.

Which is what I was addressing.

rmendpara

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #10 on: December 11, 2014, 12:13:54 PM »
401k loan Pros:
Interest is around 4-5%, plus maybe $25-50/year fee, so they are cheap.
Interest is paid to yourself within the 401k, not paid to a bank, so you keep all the money.

It acts as a bond in your 401k (fixed interest, guaranteed return on investment).
You don't have to get approval from a bank.

401k loan Cons:
If you get fired/quit you have to either pay it back in full or withdraw the outstanding balance (So don't do this if you plan to get another job soon, or aren't in a stable job situation).
You can only take out the lesser of $50k or 50% of your 401k balance.
It takes away from your other 401k investments pool, so there's an opportunity cost since that money isn't invested.
You pay it back with post-tax money (you do this for all debt, but it feels different here as a paycheck W/H so worth mentioning).[/u]
You might not be able to contribute to the 401k while the loan is outstanding (I was able to when I took out a loan for an investment, all plans are different).

To answer your specific question, yes you have to make regular payments to repay the loan. However, if you are 6 months into repayment and you want to clear the loan, you can make a payment to do so.

I've taken a 401k loan for a very specific investment purpose, and it worked out great. I repaid it within 18 months. I have an extremely stable job and was not worried about that aspect at all. I have a partner who took one out during a house repair rather than wait on the insurance company to write him a check for the damages.

Market timing - this is no different than changing your stock/bond allocation. Life circumstances change, economic outlooks change, no need to skewer someone for changing the risk they are willing to take in the market. A 401K loan will just increase your "fixed income" exposure in your portfolio.

They aren't as cheap as you might think. Let's walk through an example I haven't seen mentioned before.

You contribute to a 401k (original contribution), let's call it $10k at an effective tax rate of 25%. So effectively you defer $2.5k in taxes today to some point in the future.

Then, you take a loan against the 401k. Let's pretend it's $5k loan at 3% with no other fees (just a nice company who wants you to borrow money) and you borrow it for 1 yr. Let's also assume a lump sum payment on the last day of the year to make things simple. Assuming you're still in the 25% effective tax rate, you will have to earn another $6,666 in order to pay back the $5k loan plus interest (5k / (1-.25)) + 5k x .03 = 6,816 (amount to earn in order to pay back your loan and then have 5,150 in your 401k returned (5k plus 3% interest to yourself).

YOu can project whatever return and all, but on the amount borrowed, you will pay taxes twice:
1) when you pay back the loan
2) when you withdraw in retirement

We can make all kinds of assumptions on returns, tax rate during retirement, etc, but this seems like a horrible deal, no? Seems to me that ignoring opportunity cost and future tax assumptions, you have immediately lost $1,666 (6,816-5,150) in today's dollars.

Am I missing something?
« Last Edit: December 11, 2014, 12:17:37 PM by rmendpara »

Cheddar Stacker

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #11 on: December 11, 2014, 01:10:30 PM »
YOu can project whatever return and all, but on the amount borrowed, you will pay taxes twice:
1) when you pay back the loan
2) when you withdraw in retirement

Am I missing something?

Yeah, I think you're conflating two thoughts here. I've thought about this a lot. I tried to determine if this was a way to get extra funds into your 401k, or pay less tax, or if you end up paying more tax, or whatever. In the end I believe it's all a wash.

Contribution = Deduction.
Loan = Tax free money, just like any other loan.
Repay Loan = Paid with post tax funds, just like any other loan.
Withdrawal = Taxable.

So it looks like you pay taxes twice, but you really don't. You only pay tax on the "deferred" income (initial contribution) once, and that's upon withdrawal. Repayment of the loan is simply a use of net wages. Just like paying your car loan, or buying a car, or buying groceries. It's simply a use of cash, and it's unrelated to the initial contribution to the 401k. So you don't pay taxes twice on the amount borrowed, you pay taxes once on the amount borrowed (when you earn the funds used to repay it) and you pay taxes once on the amount deferred (when you withdrawal it) and they are two completely separate, unrelated transactions.

You will pay taxes (upon withdrawal) on the interest income the loan earned within your 401k, but that's no different than paying tax on the bond interest or dividends/cap gains from your 401k portfolio investments.

Then, you take a loan against the 401k. Let's pretend it's $5k loan at 3% with no other fees (just a nice company who wants you to borrow money) and you borrow it for 1 yr. Let's also assume a lump sum payment on the last day of the year to make things simple. Assuming you're still in the 25% effective tax rate, you will have to earn another $6,666 in order to pay back the $5k loan plus interest (5k / (1-.25)) + 5k x .03 = 6,816 (amount to earn in order to pay back your loan and then have 5,150 in your 401k returned (5k plus 3% interest to yourself).

This example is no different than any other transaction in life. When you go out to a restaurant and buy a $10 entrée, it really costs about $17.50. $10 + $1 sales tax + $2 tip = $13. $13 / (1-.25) = $17.33. So a $10 meal costs about $17.33. It's like the Triple Value of Income concept or this quote below from gocurrycracker's never pay taxes again post:

Quote
A typical middle class family man in the United States goes out for dinner with his wife at one of the nation’s many fine fast food establishments, paying $20 for a couple super sized mechanically separated chicken sandwiches, oily, starchy, and salty side dishes, insulin-bomb sodas, and artificially flavored and colored desserts.  Ignoring the long term health costs of such a decision, how much does Joe Average pay for this meal?  $20?  More like $33.50

Joe Average paid for his meal with after tax dollars.  Assuming a 25% marginal tax rate, social security and medicare taxes (both individual and employer), Joe had to earn $33.50 in order to have a $20 bill in his wallet to pay for that meal, paying $13.50 in tax before even walking into the restaurant.  Including a 10% sales tax already included in the $20 total check, $15.50 was paid in tax.  If they drove to the restaurant, they even paid tax on gas

For the same $33.50 in food spending (there is no sales tax on groceries in Washington State), we enjoyed a couple organic salads, grass-fed steaks, a side of vegetables with garlic and bacon, a couple glasses of wine, and had $10 left over.

frugalnacho

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #12 on: December 11, 2014, 01:19:05 PM »
401k loan Pros:
Interest is around 4-5%, plus maybe $25-50/year fee, so they are cheap.
Interest is paid to yourself within the 401k, not paid to a bank, so you keep all the money.

It acts as a bond in your 401k (fixed interest, guaranteed return on investment).
You don't have to get approval from a bank.

401k loan Cons:
If you get fired/quit you have to either pay it back in full or withdraw the outstanding balance (So don't do this if you plan to get another job soon, or aren't in a stable job situation).
You can only take out the lesser of $50k or 50% of your 401k balance.
It takes away from your other 401k investments pool, so there's an opportunity cost since that money isn't invested.
You pay it back with post-tax money (you do this for all debt, but it feels different here as a paycheck W/H so worth mentioning).[/u]
You might not be able to contribute to the 401k while the loan is outstanding (I was able to when I took out a loan for an investment, all plans are different).

To answer your specific question, yes you have to make regular payments to repay the loan. However, if you are 6 months into repayment and you want to clear the loan, you can make a payment to do so.

I've taken a 401k loan for a very specific investment purpose, and it worked out great. I repaid it within 18 months. I have an extremely stable job and was not worried about that aspect at all. I have a partner who took one out during a house repair rather than wait on the insurance company to write him a check for the damages.

Market timing - this is no different than changing your stock/bond allocation. Life circumstances change, economic outlooks change, no need to skewer someone for changing the risk they are willing to take in the market. A 401K loan will just increase your "fixed income" exposure in your portfolio.

They aren't as cheap as you might think. Let's walk through an example I haven't seen mentioned before.

You contribute to a 401k (original contribution), let's call it $10k at an effective tax rate of 25%. So effectively you defer $2.5k in taxes today to some point in the future.

Then, you take a loan against the 401k. Let's pretend it's $5k loan at 3% with no other fees (just a nice company who wants you to borrow money) and you borrow it for 1 yr. Let's also assume a lump sum payment on the last day of the year to make things simple. Assuming you're still in the 25% effective tax rate, you will have to earn another $6,666 in order to pay back the $5k loan plus interest (5k / (1-.25)) + 5k x .03 = 6,816 (amount to earn in order to pay back your loan and then have 5,150 in your 401k returned (5k plus 3% interest to yourself).

YOu can project whatever return and all, but on the amount borrowed, you will pay taxes twice:
1) when you pay back the loan
2) when you withdraw in retirement

We can make all kinds of assumptions on returns, tax rate during retirement, etc, but this seems like a horrible deal, no? Seems to me that ignoring opportunity cost and future tax assumptions, you have immediately lost $1,666 (6,816-5,150) in today's dollars.

Am I missing something?

I agree with cheddar stacker, you aren't paying double taxes.

Assume you take out a $5k loan...and pay it back later that day with the money you took out.  You borrow 5k, you pay back 5k. It's a wash, no actual taxes were paid.

Assume you take out the 5k and put it a checking account.  Then you take 5k from your savings account and pay the loan back.  You pay it back with "after tax" money, but then that 5k sitting in your checking account is "pre tax" money, so it's a wash. 

Wile E. Coyote

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Re: A Few Thoughts on Borrowing Against the 401k
« Reply #13 on: December 15, 2014, 04:14:53 AM »
If you thought equities were over priced and wanted to cash out so you could cash back in when they are lower...why don't you just change your asset allocation inside your 401k?  Wouldn't it be much easier to just move your entire allocation into bonds, then after the crash when stocks are cheap, move them back into stocks? 

I don't advocate market timing, nor do I think you could be successful using this strategy, but wouldn't that be easier than taking a loan out and then repaying it?

OP mentioned using the cash for a down payment on a home or investment property.

Then his next sentence was:

Then my thoughts and research led me to think about how effective it might be to borrow from the 401k (assuming it is heavily weighted towards stocks) during a period where you felt the market was getting expensive and paying it back as the price comes back down.

Which is what I was addressing.

I read them both as part of the same question.