401K loan arbitrage

[jnloca96]

Hey Mr. Money Community,

I'm not sure if I'm overlooking something but is there not a 401k loan type of arbitrage exisiting today?

The way I'm looking at it is -- I take a 401k loan out, pay 5.2% interest, the interest I pay gets put back into my 401K (earnings are taxable), I take the loan and invest it in a low risk investment (T-bill, bond, index fund) via a brokerage account or netter a Roth IRA, all while not touching my 401k investment. Am I missing something here or would this work and be financially savy?

[brooklynguy]

I'm not following what you are proposing.  What do you mean "all while not touching my 401k investment"?  If you are taking out a loan against your 401(k), then by definition you are "touching" your 401(k) investment.  And why does an arbitrage opportunity exist?  Presumably you have investment options inside your 401(k) plan that can be expected to equal or exceed the "low risk investments" you are proposing to purchase using the loan proceeds (without interfering with the tax deferred status of those dollars by temporarily pulling them outside the 401(k)).

[HazelStone]

The issues that occur to me:

1) How would the 401k funds would have been invested if you didn't try the arbitrage? There is a potential opportunity cost between the interest you pay yourself, vs. your normal 401k allocation, vs. the "low risk" investment vehicle you put it into outside. If you have really sucky 401k investment options, the move may be understandable.

2) 401k loans often involve extra fees- on mine it's a 70-$80 "service fee" if I remember correctly- regardless of how much or how little I took out. This would eat into your profits from "outside."

3) If you lose your job or choose to leave it, your 401k loan is due, in full, in very short order- and if you can't pay up you get charged income taxes and early withdrawal penalty.

4) Related to 3), if your investment "outside" declines, you may have to pay back that 401k loan in full with depreciated assets.

5) Depending on your investment vehicle outside, you could be subject to taxes on your profits.

6) I am not a lawyer, but I spent way too much time in the insurance world- retirement funds in retirement-type accounts are usually sheltered from lawsuits (to some extent). You may want to check on how funds in hand from a 401k loan would be treated in that scenario.

7) Also, many 401k administrators limit how much of your current balance you can take out on loan.

This is just what comes to mind as I eat my lunch....

[dandarc]

A 401K loan generally does take the money out of the investment.  If you have 100K in 401K and take out a 50K loan, 50K worth of shares (or whatever investment it is in) is sold, and then re-purchased over time as you pay it back.

It would have to be a higher-performing investment outside of the 401k than anything available within the 401K (rather than the lower one's specified) to make this even slightly worthwhile.

[seattlecyclone]

Yeah, I've thought a little bit about the possibilities here and think it's generally a bad idea. I mean, if you had a crystal ball that could tell you the stock market was going to go straight down for the next few years, and you had some money in taxable accounts that you would rather have in a retirement account, it might make sense to sell all your stocks, borrow as much as possible from the 401(k), and take advantage of the interest rate on the loan as a way to transfer money from taxable accounts to your 401(k). The 401(k) loan could potentially outperform all the other possible investments in your plan in that situation.

In general, though, you'll achieve a higher 401(k) balance by leaving your money invested in the plan, mostly in stocks.

[brooklynguy]

I mean, if you had a crystal ball that could tell you the stock market was going to go straight down for the next few years, and you had some money in taxable accounts that you would rather have in a retirement account, it might make sense to sell all your stocks, borrow as much as possible from the 401(k), and take advantage of the interest rate on the loan as a way to transfer money from taxable accounts to your 401(k). The 401(k) loan could potentially outperform all the other possible investments in your plan in that situation.

Even then, because you would be funding the interest payments (i.e., the dollars being transferred from your taxable accounts into your 401(k)) with after-tax dollars, you could still end up worse off if and when those dollars are taxed on the way out of the 401(k) when you eventually withdraw them.  The savings from the tax deferral on the money transferred into the 401(k) would have to outweigh the losses from the double taxation.  (And this is assuming the "crystal ball" assumptions were correct in the first place, so yeah I agree this would generally be a bad idea.)

[randommadness]

I wouldn't recommend this, but I do know people who will tap their 401k for down payments on rentals.

Taking money out of a 401k invested in stocks to invest in other stocks is rather silly.

I've taken out a 401k loan for my residence down payment. I half wish I'd just kept renting =-P

[Indexer]

I don't follow.

100k in 401k before loan.

Then you take 50k loan.

Now you have...
50k in 401k earning X% in a tax deferred account.
50k in a taxable account earning X%
- fees.

How is the loan scenario ever going to outperform the pure 401k?