Author Topic: Pay off 401k loan?  (Read 6024 times)

alexjwalk

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Pay off 401k loan?
« on: April 12, 2017, 05:33:25 PM »
A couple years ago I took out a loan from my 401k to purchase a house.  I have the cash to pay off the loan, but for some reason I cannot get my head wrapped around whether it is a good idea or not. All principal and interest get put back into my 401k account with a small fee of $6.25/year.  Other than the loan, I am maxing out my 401k annually, as well as having other savings.

Original Loan: $10,261
Interest Rate: 5.25%
Loan Duration: 15 years
Bi-weekly payment: $37.69
Annual Loan Fee: $6.25
Payoff amount: $9367.90

Thanks in advance for the help.

Alex

kayvent

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Re: Pay off 401k loan?
« Reply #1 on: April 12, 2017, 05:54:42 PM »
Time to exploit my three econ credits from years ago.

I have the cash to pay off the loan


1. Can you use that cash somewhere in a more optimal fashion, adjusting for risk, than paying off the loan? (Ex. emergency fund to offset your risk, 100% equities for the long haul, 401K at work with employer matching, etc...)
2. If you had 10,000$ less cash and no 401K loan, would you take out 10,000$ from a LOC against your home equity at the same rate?

If the answer for (1) & (2) are opposites (one yes, one no) you have some troubles; else you have a good approximate answer.

At 5.25% I personally would pay off the loan unless I need the cash for an emergency fund.
« Last Edit: April 12, 2017, 05:58:11 PM by kayvent »

Bracken_Joy

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Re: Pay off 401k loan?
« Reply #2 on: April 12, 2017, 06:04:33 PM »
At 5.25% I personally would pay off the loan unless I need the cash for an emergency fund.

+1

I find this very helpful- MDM's investing order:
Quote
WHAT
0. Establish an emergency fund to your satisfaction
1. Contribute to 401k up to any company match
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.
3. Max HSA
4. Max Roth or Traditional IRA based on income level
5. Max 401k (if 401k fees are lower than available in an IRA, swap #4 and #5)
6. Fund mega backdoor Roth if applicable
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.
8. Invest in a taxable account with any extra.

WHY
0. Give yourself at least enough buffer to avoid worries about bouncing checks
1. Company match rates are likely the highest percent return you can get on your money
2. When the guaranteed return is this high, take it.
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.
4. Rule of thumb: trad if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between
5. See #4 for choice of traditional or Roth for 401k
6. Applicability depends on the rules for the specific 401k
7. Again, take the risk-free return if high enough
8. Because earnings, even if taxed, are beneficial

Hvillian

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Re: Pay off 401k loan?
« Reply #3 on: April 13, 2017, 08:23:39 AM »
I was in the same situation a couple years ago.  I paid it back, mostly because if I changed jobs it would all have to be paid back immediately anyway (or face taxes / early withdrawal penalty).  I couldn't think of any better things to do with the money that would also keep it safe/liquid enough to be paid back if needed.

Jrr85

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Re: Pay off 401k loan?
« Reply #4 on: April 13, 2017, 08:42:16 AM »
A couple years ago I took out a loan from my 401k to purchase a house.  I have the cash to pay off the loan, but for some reason I cannot get my head wrapped around whether it is a good idea or not. All principal and interest get put back into my 401k account with a small fee of $6.25/year.  Other than the loan, I am maxing out my 401k annually, as well as having other savings.

Original Loan: $10,261
Interest Rate: 5.25%
Loan Duration: 15 years
Bi-weekly payment: $37.69
Annual Loan Fee: $6.25
Payoff amount: $9367.90

Thanks in advance for the help.

Alex

I would say pay it off quickly to avoid the double tax hit on the interest.  You are paying yourself the interest with after tax dollars.  And then assuming the 401k is not a roth 401k loan, when you eventually take the interest you paid yourself out through a withdrawal, you will be paying income taxes on it again.  You do get the benefit of that interest growing tax free in the mean time, but I'd rather put that money into a tax efficient ETF rather than pay income taxes on it again. 

If you expect your withdrawals in retirement to be so low that you won't pay tax on it, then maybe getting that taxfree growth in the interim is a good deal.  Otherwise I think the taxes are going to wipe out any benefit of deferring the taxes on the growth of the interest paid.  Make sense? 

nobody123

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Re: Pay off 401k loan?
« Reply #5 on: April 13, 2017, 01:19:32 PM »
I would say pay it off quickly to avoid the double tax hit on the interest.  You are paying yourself the interest with after tax dollars.  And then assuming the 401k is not a roth 401k loan, when you eventually take the interest you paid yourself out through a withdrawal, you will be paying income taxes on it again.  You do get the benefit of that interest growing tax free in the mean time, but I'd rather put that money into a tax efficient ETF rather than pay income taxes on it again. 

Pet peeve of mine.  Interest paid on a 401k loan is not double-taxed.  Your 401k just used some assets to buy another asset (the income stream from the loan), and its returns on that investment (aka the interest) is tax deferred until you take a distribution, like any other asset the 401k could have held.  No matter what the source of the (non-mortgage or HELOC) loan the OP took, he was going to repay the loan and interest with after tax dollars.  Just because he took the loan from his 401k doesn't make the interest double-taxed.  There's a good recent thread explaining this.

frugaliknowit

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Re: Pay off 401k loan?
« Reply #6 on: April 13, 2017, 01:35:57 PM »
Pay it off if you have enough EF cash or if you are planning on quitting your job.

Jrr85

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Re: Pay off 401k loan?
« Reply #7 on: April 13, 2017, 04:10:14 PM »
I would say pay it off quickly to avoid the double tax hit on the interest.  You are paying yourself the interest with after tax dollars.  And then assuming the 401k is not a roth 401k loan, when you eventually take the interest you paid yourself out through a withdrawal, you will be paying income taxes on it again.  You do get the benefit of that interest growing tax free in the mean time, but I'd rather put that money into a tax efficient ETF rather than pay income taxes on it again. 

Pet peeve of mine.  Interest paid on a 401k loan is not double-taxed.  Your 401k just used some assets to buy another asset (the income stream from the loan), and its returns on that investment (aka the interest) is tax deferred until you take a distribution, like any other asset the 401k could have held.  No matter what the source of the (non-mortgage or HELOC) loan the OP took, he was going to repay the loan and interest with after tax dollars.  Just because he took the loan from his 401k doesn't make the interest double-taxed.  There's a good recent thread explaining this.

To clarify, the double tax hit is paying taxes on it twice as earned income.  Instead of putting that after tax money into the 401k, getting tax deferred gain, and then paying taxes on the gain as earned income, he/she could put the after tax money into a tax efficient ETF, maybe one tilted more towards growth to limit dividends or even just one that generally only pays out qualified dividends, so that the tax rate is the long term capital gain rate rather than the rate for earned income. 

Or am I still missing something?   

ETA:  If you are just talking about comparing a HELOC to a 401k loan, you are right.  If you are comparing paying off a 401k loan versus letting it ride, I think I am right if I'm not missing anything (although I'm not sure the magnitude is that big of a deal).  The more interest you pay (i.e., the longer you let it ride), the more after tax money you invest where the gains will be subject to earned income tax rates rather than long term capital gain rates. 
« Last Edit: April 13, 2017, 04:13:39 PM by Jrr85 »

alexjwalk

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Re: Pay off 401k loan?
« Reply #8 on: April 13, 2017, 08:12:40 PM »
Thank you all very much for the thoughtful responses!  I appreciate the help.

rpr

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Re: Pay off 401k loan?
« Reply #9 on: April 13, 2017, 08:22:41 PM »

To clarify, the double tax hit is paying taxes on it twice as earned income

Here is a simplified case. You need $1000. Your 401k balance is at $1000. Market returns, 401k loan rates, bank loan rates are all at 10%. You borrow for one year. Also assume that you can borrow 100% of your 401k balance.

Option A: Bank loan.
Need to pay back to the bank $1100 using after tax $
Balance in 401k $1100.

Option B: 401k loan
Need to pay back to the 401k $1100 using after tax $
Balance in 401k $1100.

No difference between the two scenarios. Obviously if rates are different, then optimal method will also be different.

Viking Thor

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Re: Pay off 401k loan?
« Reply #10 on: April 13, 2017, 08:41:36 PM »
As several have mentioned, the double tax is a widely held misconception. Also, the "interest rate" on the loan doesn't really matter because it's interest you are paying to yourself.

As mentioned earlier, there is the risk of losing your job or leaving the company and having to pay it back. Some companies allow you to pay the 401k loan in installments even after you leave while others require a lump sum repayment due shortly after leaving, or face taxes / early withdrawal penalty.

There is no urgent reason to pay it back quickly, but if you have the funds available it could be a good idea as that alleviates any payback concerns if you leave job in future and you can put the money to work productively in your 401k.

maricela

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Re: Pay off 401k loan?
« Reply #11 on: April 16, 2017, 12:31:06 PM »
You will be making more than 5% in the market on average. Pay it back 


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Laura33

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Re: Pay off 401k loan?
« Reply #12 on: April 16, 2017, 04:39:47 PM »
The reason this matters for most people is that they are borrowing money they can't pay back quickly.  So they are removing $10K from the market, using it to buy stuff (in many cases consumables), and instead earning a 5.25% "return" on that money as they pay it back with interest.  So there is a very real loss of the opportunity to make market returns.

OTOH, if you have the money, and your choice is whether to pay off the 401(k) loan or put that same money in VSTAX outside your 401(k) while continuing to pay off the loan on the regular schedule, it doesn't matter as much; that money is still going to be in the market instead of being spent on consumables, the only question is whether it is invested inside or outside your 401(k).  I guess the real question is what would you do with the $75/mo. if you weren't paying back the loan?  Right now, you are basically using it to buy [however many years are left of] a 15-year bond with a 5.25% interest rate.  Is that what you would prefer to do with that money?  Or would you rather invest it elsewhere? 

Viking Thor

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Re: Pay off 401k loan?
« Reply #13 on: April 16, 2017, 10:08:23 PM »
If I could take a 401k loan at 100% interest rate I would do it. Why? You are paying YOURSELF. The interest rate doesn't really matter that much.

But since I max my 401k, I would take out a loan at 100% interest since that would allow me to put more funds into 401k and get tax deferred growth.

That's an extreme example and would never happen as you don't control the 401k loan rate and it's probably around 5%, but point is the interest rate on a 401k loan doesn't really matter.

If you have the funds, it could make sense to pay off the 401k loan to be done with it and put your money to work in the 401k, but the interest rate on loan to yourself shouldn't factor into the decision.

nobody123

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Re: Pay off 401k loan?
« Reply #14 on: April 17, 2017, 07:41:05 AM »
If I could take a 401k loan at 100% interest rate I would do it. Why? You are paying YOURSELF. The interest rate doesn't really matter that much.

But since I max my 401k, I would take out a loan at 100% interest since that would allow me to put more funds into 401k and get tax deferred growth.

That's an extreme example and would never happen as you don't control the 401k loan rate and it's probably around 5%, but point is the interest rate on a 401k loan doesn't really matter.

If you have the funds, it could make sense to pay off the 401k loan to be done with it and put your money to work in the 401k, but the interest rate on loan to yourself shouldn't factor into the decision.

This made my head hurt.

So, let's say you're in the 20% tax bracket.  You borrow $10K from your 401k at 100% interest for 1 year.  Assuming you just hold the principal in your mattress to pay the loan back, you need to pay back $10K in after-tax dollars for interest.  So you have to earn $12,500 (actually more, since this doesn't include state / local taxes, FICA, etc.) to pay for the interest to get that $10K into your 401k.  Plus, you've lost the $700 in hypothetical market gains on the $10k you pulled out as part of the loan.

Assume: $100K 401k balance, lump sum loan repayment after 1 year (just to make the math easy).

Scenario A.  Take out $10K loan.  $90K remaining grows to $96,300.  Add loan payback of $20K gets you $116,300 in assets in 401k after year 1.  Take away $2500 in taxes paid on the interest, you have $113,800 net. edit:  Fell into the trap of double-counting this.

Scenario B.  No loan.  $100K grows to $107,000.  $10,000 in taxable savings on your $12.5K in earnings.  $117,000 net assets.

You're $3200 $700 ahead by not taking the loan after year 1.

« Last Edit: April 18, 2017, 08:16:21 AM by nobody123 »

Viking Thor

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Re: Pay off 401k loan?
« Reply #15 on: April 17, 2017, 01:54:09 PM »
Again they don't allow 100% 401k loan but if they did and I could set a short term loan length, I would do the following:
Take out a manageable sized 401k loan. Invest it in a taxable account and keep it invested long term. Of course it would not go under a mattress, that would defeat the purpose.

Pay back the 401k loan plus 100% interest into the 401k.

In effect this would just be a way to put more investment into 401k instead of taxable investment if there is no more tax deferred space available to invest.

The point of my example is not to do this in practice  since the option does not exist, it's that people should not be overly focused on or fearful of the 401k loan rate since you are paying yourself back.

nobody123

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Re: Pay off 401k loan?
« Reply #16 on: April 18, 2017, 08:33:09 AM »
Again they don't allow 100% 401k loan but if they did and I could set a short term loan length, I would do the following:
Take out a manageable sized 401k loan. Invest it in a taxable account and keep it invested long term. Of course it would not go under a mattress, that would defeat the purpose.

Pay back the 401k loan plus 100% interest into the 401k.

In effect this would just be a way to put more investment into 401k instead of taxable investment if there is no more tax deferred space available to invest.

Note: I revised my previous post because I double-counted the taxes paid in one scenario.

So you want to take money out of a tax-deferred account via a loan, invest those dollars in a taxable account, and then pay tax on the income required to pay the loan back, all under the assumption that it will put more money in your tax deferred account and you'll be in a better net financial position?  That can only make sense if there is zero cost to the 401k loan.

Let's revisit the prior scenarios.  Assume: $100K 401k balance, lump sum loan repayment after 1 year (just to make the math easy).

Scenario A.  Take out $10K loan.  $90K remaining grows to $96,300.  Earn $25K, pay $5K in taxes, and use remaining $20K to pay back loan.  $116,300 in assets in 401k after year 1.  $10,700 in taxable account.  $127,000 total assets.

Scenario B.  No loan.  $100K grows to $107,000.  $20,000 in taxable savings on your $25K in earnings.  $127,000 total assets.

I'll concede that you achieved your goal of putting more money into your 401k.  Except you need to also cover the loan fees in scenario A, so you'll be slightly behind in dollars.  Assuming you can invest in the same things both inside and outside of your 401k, you'd have to make assumptions on future tax liabilities to say scenario A is ultimately better.

Quote
The point of my example is not to do this in practice  since the option does not exist, it's that people should not be overly focused on or fearful of the 401k loan rate since you are paying yourself back.

The loan rate is absolutely relevant.  If I can borrow money to buy a car from the bank at 3% or my 401k at 5% what one is better?  The 3% bank loan every day of the week.  Bank loan or 401k loan, you have to use after tax dollars to pay the interest.  You want to pay the least amount of interest.  Bank loan at 6% or 401k loan at 5%?  The bank loan at 6%, assuming 7% market returns on your 401k.

You are not "paying yourself back" when you take out a 401k loan.  That is a common misconception.  You are taking out a loan.  401k is shifting its assests.  They are two separate, independent things.  If your 401k could loan me money, I wouldn't be able to say that I'm paying myself back, but I'd still be using my after-tax dollars to repay the loan.  There is nothing magical about a 401k loan, other than the fact it doesn't care about your credit score when you take it out.

Viking Thor

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Re: Pay off 401k loan?
« Reply #17 on: April 18, 2017, 09:10:35 AM »
I am not going to drag this out, other than to say there is no double taxation and you are paying yourself interest. The double taxation of 401k loans is a myth with a whole recent thread devoted to the topic.

If you can't see the difference between paying interest to a bank versus paying interest to yourself that goes into your own 401k (which is your money), then I give up explaining. We'll have to agree to disagree.

Proud Foot

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Re: Pay off 401k loan?
« Reply #18 on: April 18, 2017, 11:20:51 AM »
I am not going to drag this out, other than to say there is no double taxation and you are paying yourself interest. The double taxation of 401k loans is a myth with a whole recent thread devoted to the topic.

If you can't see the difference between paying interest to a bank versus paying interest to yourself that goes into your own 401k (which is your money which you pay tax on again when you take a distribution from the account), then I give up explaining. We'll have to agree to disagree.

Viking,  I am of the same opinion as nobody123 on the double taxation issue.  However, I think it is overblown by the personal finance gurus when discussing whether to take out or pay off a 401k loan.  There are many other things to consider which have a lot more bearing on whether it is good for you or not.  While I do agree with you that there is no difference in paying interest to yourself versus paying interest to the bank, the difference comes down the road when you start taking distributions from your account.  I bolded my addition to your quote above.

Jrr85

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Re: Pay off 401k loan?
« Reply #19 on: April 18, 2017, 11:22:39 AM »
I am not going to drag this out, other than to say there is no double taxation and you are paying yourself interest. The double taxation of 401k loans is a myth with a whole recent thread devoted to the topic.

If you can't see the difference between paying interest to a bank versus paying interest to yourself that goes into your own 401k (which is your money), then I give up explaining. We'll have to agree to disagree.

People keep saying this but don't address the impact of paying ordinary income tax versus taxes on capital games or preferred dividends.  With so many investments that grow while creating minimal (or no) taxable events each year, it doesn't seem like the deferrals on interim gains is worth the hit from ultimately having the gains taxed as ordinary income.