Borrowing from 401k equivalent to buy identical investment

[Full_Beard]

What's wrong with this:

1. Borrow $50K from 401(k) -- technically, it's the Thrift Savings Plan TSP for federal gov't employees
2. Purchase S&P 500 shares -- most of TSP is in that fund.

The pros: 

(a) I have effectively transferred tax-deferred savings into taxable savings and pay no penalty.
(b) I pay an extra $1000 per month into my TSP for the debt, so I'm now contributing another $12K per year into my TSP.
(c) There is no lost investment opportunity since the money is invested in an identical index fund.

Cons:

(a) I could lose the job -- extremely unlikely since it's with the fed. govt and I have seniority in my group.
(b) Some taxes from dividends of index fund.

What am I missing?

[Jags4186]

I see no benefit to this:

1) Your money will grow faster in the TSP than it will in a taxable account because, as you've correctly identified, you will be taxed on the dividends your S&P 500 fund pays out in a taxable account.  You won't be in the TSP.

2) You will have to pay back the loan with after-tax dollars so you will not be gaining ground.

Unless you need the money for something I would just build your taxable account with whatever is left over after maxing your tax deferred accounts.

[MDM]

2) You will have to pay back the loan with after-tax dollars so you will not be gaining ground.

That is the big one. 

E.g., if you have a 30% marginal rate (federal + state) it will cost $71,429 to repay the $50K loan.  Then you get to pay 30% again when you withdraw money because withdrawals are taxed as ordinary income.

[Full_Beard]

I think paying back the loan with after-tax dollars is the kicker.

Saying the TSP grows faster needs to be parsed out. The TSP and the taxable accounts, as distinct stand-alone accounts, will grow at the same rate. However, I'll have to pay some taxes each year on the dividends in the taxable account (but on $50K, that's not that much), which on a ledger, you could deduct from the taxable account's value, so in that sense, it's not "growing" as fast. But that is not a big difference.

I'm not sure how you calculated the marginal rate to calculate the cost of the loan. Whatever the cost, however, it all goes to me since it's a loan to myself (and the interest is approximately 2%), right? Also, the interest/gains from the loan are not presently taxable since the loan is inside of the TSP. So, I don't know how that's an issue. Yes, I'll pay taxes on the TSP withdrawals later, but that's true however I earn the money.

[MDM]

E.g., if you have a 30% marginal rate (federal + state) it will cost $71,429 to repay the $50K loan.

I'm not sure how you calculated the marginal rate to calculate the cost of the loan.

Marginal rate was assumed (e.g., 25% federal, 5% state), not calculated.  Interest was ignored for simplicity, and to treat the loan most favorably.  The $50,000/(1-30%) = $71,429 is the pre-tax cost to put $50K back into the TSP.  That is the same cost as leaving the TSP alone but investing $50K into a taxable account.

Any interest you pay into the TSP is coming from taxed income.  If you invested that into a taxable account, you pay some amount on yearly dividends/interest, but get the favorable rates on capital gains when withdrawing.  The interest into the TSP does grow tax free, but it and its gains are taxed at ordinary rates when withdrawing.

[frugalnacho]

Regarding Pro (b), you really aren't contributing $12k more into the tsp.  You are contributing back what you already borrowed.  You are still in the hole for the tsp.  If you have the extra cash to dump into the tsp, just forget your plan altogether and contribute that $1k/mo directly into a taxable account at vanguard.

As for paying back the 401k loan with "after tax" money, it's a bit of a red herring. 

Say you have $50k in your 401k.  You pull that money out, and they give it all to you "tax free".  Now you have to pay back a $50k loan with "after tax" money and everyone thinks you are getting royally screwed and paying taxes twice, but are you really?  Suppose you also have $50k cash in your wallet.  Now you borrow $50k from your 401k to make some purchase.  Immediately after you purchase your $50k asset you take the cash out of your wallet and go pay back all $50k of your 401k loan.  Now your 401k balance is back to $50k, your wallet is $0k, and you have a $50k asset.  You didn't get screwed on taxes because the money you pulled out was never taxed in the first place.  You paid taxes on the cash you used to purchase your $50k asset, but not on the original money you contributed to your 401k. 

Usually 401k loans are not straight up loans with no interest that you pay yourself.  It usually involves some kind of interest, and THAT is where you get screwed on taxes, because that extra amount you pay back is actually double taxed.  It's taxed when you earn it, then you put it into the 401k and you get taxed again when you eventually take it out.  But that only applies to the extra amount you pay above the original loan.