Author Topic: 401k loan to fund taxable investments  (Read 1503 times)

PDXTabs

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401k loan to fund taxable investments
« on: April 08, 2022, 03:51:48 PM »
I have one of those not-great 401(k)s with poor fees and fund selection. The best option that I have is a Russell 1000 index fund with a 0.79% fee.

Right now I can borrow from this 401k at 4.5%. That 4.5% would be paid to myself but ends up getting double taxed (because all of the interest is paid with after-tax dollars and then later the withdrawal will also be taxed). Additionally there is a $75 fee to setup the loan and a $50/yr maintenance fee. My 401k lets me continue to contribute while the loan is out so I can still max it out to minimize my AGI.

With inflation running higher than the 4.5% that I would have to pay to myself and lower fee options available in a taxable brokerage should I consider taking the maximum 401k loan to fund taxable investments?

Dicey

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Re: 401k loan to fund taxable investments
« Reply #1 on: April 08, 2022, 08:30:20 PM »
I have one of those not-great 401(k)s with poor fees and fund selection. The best option that I have is a Russell 1000 index fund with a 0.79% fee.

Right now I can borrow from this 401k at 4.5%. That 4.5% would be paid to myself but ends up getting double taxed (because all of the interest is paid with after-tax dollars and then later the withdrawal will also be taxed). Additionally there is a $75 fee to setup the loan and a $50/yr maintenance fee. My 401k lets me continue to contribute while the loan is out so I can still max it out to minimize my AGI.

With inflation running higher than the 4.5% that I would have to pay to myself and lower fee options available in a taxable brokerage should I consider taking the maximum 401k loan to fund taxable investments?
I did one once for a reason that paid off handsomely (real estate), but I'd never do it again. I felt like an indentured servant and despised the loan every moment I had it. Feeling trapped in my job sucked.

PDXTabs

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Re: 401k loan to fund taxable investments
« Reply #2 on: April 08, 2022, 09:49:40 PM »
I did one once for a reason that paid off handsomely (real estate), but I'd never do it again. I felt like an indentured servant and despised the loan every moment I had it. Feeling trapped in my job sucked.

That makes sense and I worry about that. But if I had enough in a taxable account to pay it off it would just be a matter of selling ETFs and paying the tax man. Obviously I would want enough available to come up with the money.

Telecaster

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Re: 401k loan to fund taxable investments
« Reply #3 on: April 08, 2022, 10:00:36 PM »
I have one of those not-great 401(k)s with poor fees and fund selection. The best option that I have is a Russell 1000 index fund with a 0.79% fee.

Right now I can borrow from this 401k at 4.5%. That 4.5% would be paid to myself but ends up getting double taxed (because all of the interest is paid with after-tax dollars and then later the withdrawal will also be taxed). Additionally there is a $75 fee to setup the loan and a $50/yr maintenance fee. My 401k lets me continue to contribute while the loan is out so I can still max it out to minimize my AGI.

With inflation running higher than the 4.5% that I would have to pay to myself and lower fee options available in a taxable brokerage should I consider taking the maximum 401k loan to fund taxable investments?

I probably would not do this.  Think of the .079% fee as $8 per thousand.  The double tax issue alone (good for you for realizing this, lots of people miss it) is probably higher than the 0.79% fee.  Add in the set up and maintenance fees and it is hard to see much savings.


PDXTabs

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Re: 401k loan to fund taxable investments
« Reply #4 on: April 08, 2022, 10:22:36 PM »
I probably would not do this.  Think of the .079% fee as $8 per thousand.  The double tax issue alone (good for you for realizing this, lots of people miss it) is probably higher than the 0.79% fee.  Add in the set up and maintenance fees and it is hard to see much savings.

I think that you are right. I was trying to figure out how to think about it. I would pay ~$2,060 in interest the first year plus the origination fee. The interest is paid to myself so I think that we can just ignore that (moving money from my left pocket to my right pocket is irrelevant). But I'd be double taxed on that $2,060. Meanwhile I might save ~$270 in fees.

seattlecyclone

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Re: 401k loan to fund taxable investments
« Reply #5 on: April 08, 2022, 10:41:30 PM »
A 401(k) loan doesn't result in any unique double taxation.

Suppose you borrow some money from a bank at 4.5% to invest in taxable index funds. Suppose you separately put your 401(k) balance into a fixed-income investment that yields 4.5%. Is any double taxation happening here? I'd say no. The income in your 401(k) will be taxed the same as any other investment you might make in that account, and any gains in your taxable account will be subject to normal capital gain rates. Nothing is taxed twice.

The tax treatment of a 401(k) loan is the exactly the same as for the set of transactions I described above. If those transactions weren't doubly taxed, how can this set be doubly taxed?

Now, as to your original question I have two to send right back at you:
1) Do you think it's worth paying 4.5% interest to buy stocks with leverage?
2) Is a fixed 4.5% return one of the best things you can do with your 401(k) plan balance?

If yes to both, this might be worth exploring. Somehow I think you might be able to come up with a better plan.

PDXTabs

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Re: 401k loan to fund taxable investments
« Reply #6 on: April 08, 2022, 10:49:56 PM »
Now, as to your original question I have two to send right back at you:
1) Do you think it's worth paying 4.5% interest to buy stocks with leverage?

If I could take out a five year fixed rate 4.5% margin loan that would never be called I would probably do it in today's environment. But I don't think that's what we're talking about, because I'm selling 401k assets to buy taxable assets and then paying myself interest. I don't think that's leverage.

Somehow I think you might be able to come up with a better plan.

The best plan would be to quit this job and roll the 401k into an IRA with reasonable fees, but I'm not ready to do that yet.

seattlecyclone

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Re: 401k loan to fund taxable investments
« Reply #7 on: April 08, 2022, 11:24:52 PM »
Now, as to your original question I have two to send right back at you:
1) Do you think it's worth paying 4.5% interest to buy stocks with leverage?

If I could take out a five year fixed rate 4.5% margin loan that would never be called I would probably do it in today's environment. But I don't think that's what we're talking about, because I'm selling 401k assets to buy taxable assets and then paying myself interest. I don't think that's leverage.


Borrowing from your 401(k) is leverage in exactly the same way as borrowing from a third party and then lending your 401(k) to another party is leverage. If you would say "well my margin loan doesn't count as leverage because I have bonds in my 401(k)" then the same would apply here.

PDXTabs

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Re: 401k loan to fund taxable investments
« Reply #8 on: April 08, 2022, 11:35:30 PM »
Now, as to your original question I have two to send right back at you:
1) Do you think it's worth paying 4.5% interest to buy stocks with leverage?

If I could take out a five year fixed rate 4.5% margin loan that would never be called I would probably do it in today's environment. But I don't think that's what we're talking about, because I'm selling 401k assets to buy taxable assets and then paying myself interest. I don't think that's leverage.


Borrowing from your 401(k) is leverage in exactly the same way as borrowing from a third party and then lending your 401(k) to another party is leverage. If you would say "well my margin loan doesn't count as leverage because I have bonds in my 401(k)" then the same would apply here.

Where's the leverage? A 401k loan is not the same as a margin loan because a margin loan doesn't force you to sell $50k worth of assets to get a $50k loan.

seattlecyclone

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Re: 401k loan to fund taxable investments
« Reply #9 on: April 09, 2022, 09:57:59 AM »
Now, as to your original question I have two to send right back at you:
1) Do you think it's worth paying 4.5% interest to buy stocks with leverage?

If I could take out a five year fixed rate 4.5% margin loan that would never be called I would probably do it in today's environment. But I don't think that's what we're talking about, because I'm selling 401k assets to buy taxable assets and then paying myself interest. I don't think that's leverage.


Borrowing from your 401(k) is leverage in exactly the same way as borrowing from a third party and then lending your 401(k) to another party is leverage. If you would say "well my margin loan doesn't count as leverage because I have bonds in my 401(k)" then the same would apply here.

Where's the leverage? A 401k loan is not the same as a margin loan because a margin loan doesn't force you to sell $50k worth of assets to get a $50k loan.

You (the taxable entity) are borrowing money to buy stocks. Your 401(k) is increasing its fixed-income position by that same amount. Do those cancel out so that there's no net leverage? Maybe! It's a matter of semantics I guess. Just be consistent about it. Whether there's a third party involved in these transactions doesn't really change the underlying profile of the borrowing activity. Just as with a margin loan, you (the taxable entity) could be at a disadvantage if the 401(k) loan comes due during a stock market downturn.

reeshau

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Re: 401k loan to fund taxable investments
« Reply #10 on: April 09, 2022, 12:39:06 PM »
I did one once for a reason that paid off handsomely (real estate), but I'd never do it again. I felt like an indentured servant and despised the loan every moment I had it. Feeling trapped in my job sucked.

That makes sense and I worry about that. But if I had enough in a taxable account to pay it off it would just be a matter of selling ETFs and paying the tax man. Obviously I would want enough available to come up with the money.

The situation that would really hurt is if you were laid off.  The loan is immediately due on separation, including termination of employment.  Assuming that happens without cause, it's probably some kind of economic downturn.  Which means, you'd be cashing out at a depressed market price.  Good news:  no taxes on a loss.  Bad news:  realized losses, vs. the financial and mental costs of having that loan.

That's not the likely scenario, but it's possible.  It's a lot of work and anguish for some potential maximization.

Notice I don't call it optimization.

Does your employer allow in-service rollovers?  Note, if you do roll over to an IRA, that has implications to your backdoor Roth, and wouldn't be eligible for rule of 55 withdrawals.

PDXTabs

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Re: 401k loan to fund taxable investments
« Reply #11 on: April 09, 2022, 12:50:33 PM »
That makes sense and I worry about that. But if I had enough in a taxable account to pay it off it would just be a matter of selling ETFs and paying the tax man. Obviously I would want enough available to come up with the money.

The situation that would really hurt is if you were laid off.  The loan is immediately due on separation, including termination of employment.  Assuming that happens without cause, it's probably some kind of economic downturn.  Which means, you'd be cashing out at a depressed market price.  Good news:  no taxes on a loss.  Bad news:  realized losses, vs. the financial and mental costs of having that loan.

A couple of points:
1. Not all 401(k)s require you to immediately pay back the loan (but I believe that this one does).
2. You now have until your tax filing deadline to pay back the loan. https://www.creditkarma.com/tax/i/401k-tax-reform-loan-repay

I'm not sure how "bad" it is for me to have to realize the loss. I could carry it over to future tax years.

Does your employer allow in-service rollovers?  Note, if you do roll over to an IRA, that has implications to your backdoor Roth, and wouldn't be eligible for rule of 55 withdrawals.

Nope, I wish.

PDXTabs

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Re: 401k loan to fund taxable investments
« Reply #12 on: April 09, 2022, 12:54:08 PM »
You (the taxable entity) are borrowing money to buy stocks. Your 401(k) is increasing its fixed-income position by that same amount. Do those cancel out so that there's no net leverage? Maybe! It's a matter of semantics I guess.

That's how I see it, but I'm willing to have my mind changed.

You do however allude to an interesting point: if I was selling fixed income in my 401k to fund this scheme it might be different. But I would be selling equities to buy more equities.

Honestly I find the whole thing a little confusing to think about. I've definitely seen economists talk about how you can't borrow money from yourself. It's a made-up idea. If I used envelope accounting and transferred money from my restaurant envelope to my gas envelope nothing changed except in my head.
« Last Edit: April 09, 2022, 12:58:08 PM by PDXTabs »

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Re: 401k loan to fund taxable investments
« Reply #13 on: April 09, 2022, 06:16:47 PM »
If I could take out a five year fixed rate 4.5% margin loan that would never be called I would probably do it in today's environment.
IBKR Pro ($10/mo) charges 1.83% for margin loans, but I expect that to keep pace with Fed rate hikes.  So it could hit 4.5% by year end.
https://www.interactivebrokers.com/en/trading/margin-rates.php

In general, high leverage meeting asset losses triggers margin calls.  If you're using a responsible amount of leverage (1.25x or 1.33x) that shoudn't happen.  In 2020 I planned how I would handle losses before I bought on margin, so I would already be selling and closing the margin loan as those loses add up.  I don't expect to use margin again unless the market holds a really good sale.

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Re: 401k loan to fund taxable investments
« Reply #14 on: April 09, 2022, 07:58:35 PM »
You (the taxable entity) are borrowing money to buy stocks. Your 401(k) is increasing its fixed-income position by that same amount. Do those cancel out so that there's no net leverage? Maybe! It's a matter of semantics I guess.

That's how I see it, but I'm willing to have my mind changed.

You do however allude to an interesting point: if I was selling fixed income in my 401k to fund this scheme it might be different. But I would be selling equities to buy more equities.

Honestly I find the whole thing a little confusing to think about. I've definitely seen economists talk about how you can't borrow money from yourself. It's a made-up idea. If I used envelope accounting and transferred money from my restaurant envelope to my gas envelope nothing changed except in my head.

A 401(k) loan isn't exactly the same as transferring cash from one envelope to another. Your 401(k) isn't just another bank account that you can move cash into and out of willy-nilly. It's a trust established on your behalf that has specific rules about contributions and withdrawals, with tax implications for such transactions. You won't be charged a 10% penalty by the government for failure to reimburse your restaurant envelope according to the designated schedule. With a 401(k) loan you will.

Dicey

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Re: 401k loan to fund taxable investments
« Reply #15 on: April 09, 2022, 09:36:11 PM »
Just because you can doesn't mean you should. I only borrowed $6k as a bridge loan between properties and I paid it off in under a year. I was probably only earning $40k/year at the time. I absofuckinglutely hated it.

Another point is that the money you're borrowing is already in the market. You're going to borrow money that's in the market to...invest it in the market? It just doesn't seem worth the risk or the strings. I'd rather see someone do a cash out re-fi than borrow from their 401k.

I still consider it the worst financial mistake of my life.

PDXTabs

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Re: 401k loan to fund taxable investments
« Reply #16 on: April 09, 2022, 10:49:45 PM »
Just because you can doesn't mean you should. I only borrowed $6k as a bridge loan between properties and I paid it off in under a year. I was probably only earning $40k/year at the time. I absofuckinglutely hated it.

I agree. Along those lines one of the ways to eliminate the risk would be to carry an extra $50k of cash. But then I'd have an extra $50k of cash which would completely defeat the whole point.

I'd rather see someone do a cash out re-fi than borrow from their 401k.

If I was in the position to do that I absolutely would.