Author Topic: The exact math behind using 401k loan to pay down debt  (Read 23016 times)

SanDiegoFIRE

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The exact math behind using 401k loan to pay down debt
« on: May 20, 2015, 09:39:13 PM »
would like some opinions on this please

I currently have a sizable 401k that is entirely invested in a (low-cost) stable value fund (think short term bonds).  The equity investment funds available in the 401k are all high fee (>1%) with no index options, so I park the balance in the low fee stable value and use it as the cash/short-term bond portion of our asset allocation.

The interest rate on a 401k loan is 4.125%.  Taking a loan does not affect ability to contribute to 401k, which I max every year due to being in highest tax bracket.  My job is stable and I have no plans to leave it in the near future.  If I were to get laid off I would receive a huge severance package as well as deferred comp that vests immediately, so I would easily be able to pay off any 401k loan balance and have a big amount left over.

We have various fixed rate mortgages on investment properties, the highest being 4.625%.  We also have many taxable accounts with large balances fully invested in equity index funds.  Given the current 0% rate environment, I try to keep as little cash as possible, except in the 401k due to the lack of low cost investment options.

The question I have is, does it make sense to take a loan on the 401k at 4.125% and use proceeds to pay down the highest rate (4.625%) mortgage?  I figured that since the 4.125% 401k loan interest would be paid to myself, using loan proceeds to pay off higher rate debt would make sense since I have no plans to invest the 401k balance in anything other than cash-like equivalents, and have no concerns about ability to repay the loan if my employment situation were to change.

Are there any other considerations I am missing?  One thought was that the interest I pay myself which accrues in the 401k account would be paid with after-tax dollars, but would then again be taxed upon eventual withdrawal - is this correct?

Thanks in advance

trailrated

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Re: The exact math behind using 401k loan to pay down debt
« Reply #1 on: May 20, 2015, 11:06:57 PM »
Sounds like a lot of work and some added risk (or at least hassle, if your job is that stable) to save .5% interest. How much is left to pay off the mortgage? How fast would you repay the loan?

SanDiegoFIRE

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Re: The exact math behind using 401k loan to pay down debt
« Reply #2 on: May 21, 2015, 12:46:27 AM »
Sounds like a lot of work and some added risk (or at least hassle, if your job is that stable) to save .5% interest. How much is left to pay off the mortgage? How fast would you repay the loan?

Your 401k is the recipient of the interest, so the savings is a lot more than 0.5%.  And on larger amounts it can really add up over the course of a working career.

kpd905

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Re: The exact math behind using 401k loan to pay down debt
« Reply #3 on: May 21, 2015, 06:06:48 AM »
Off topic, but I think you'd be better off having your money invested in some type of stock fund even with a 1% expense ratio.

forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #4 on: May 21, 2015, 07:09:30 AM »
I don't think the 0.5% spread is worth the hassle. Also, I believe you have to pay the 401k interest back into your account, right? So you're paying taxes on money, using that money to pay your interest, and then when you pull it back out, you're paying taxes on it again. This sounds like a bad idea.

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #5 on: May 21, 2015, 07:13:05 AM »
The 401k interest rate is irrelevant to the question.  The comparison that needs to be made is the mortgage rate versus the return in the stable value fund.

shotgunwilly

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Re: The exact math behind using 401k loan to pay down debt
« Reply #6 on: May 21, 2015, 07:47:55 AM »
The 401k interest rate is irrelevant to the question.  The comparison that needs to be made is the mortgage rate versus the return in the stable value fund.

+1

Some people aren't understanding that the interest rate on the 401k loan isn't money you're losing. You are paying yourself the interest, so it's like forcing extra savings.

forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #7 on: May 21, 2015, 08:16:31 AM »
The 401k interest rate is irrelevant to the question.  The comparison that needs to be made is the mortgage rate versus the return in the stable value fund.

+1

Some people aren't understanding that the interest rate on the 401k loan isn't money you're losing. You are paying yourself the interest, so it's like forcing extra savings.

But taxing yourself twice on that savings.

seattlecyclone

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Re: The exact math behind using 401k loan to pay down debt
« Reply #8 on: May 21, 2015, 08:56:42 AM »
The double taxation is a myth. You're not being taxed any more by doing this than you would be otherwise. You would repay the 401(k) loan with after-tax funds just like you're repaying your current loan with after-tax funds. Nothing is changing on that side of equation. Within the 401(k), the treatment of the interest is no different than if you loaned money to a third party (aka you bought a bond). In effect, the OP is proposing to do exactly this with their 401(k): buy the loan from the bank and collect interest on it.

So the question is whether buying that loan is a good investment. Sure, you won't be paying interest to the bank anymore, and you'll be increasing the value of your 401(k) as you make payments. But you have to remember that the amount you loaned out is no longer invested in index funds, so you're deciding to accept a fixed return of 4.25% on that money rather than a likely higher return from the market.

Really this is just a more complicated version of the "should I pay off my mortgage sooner or invest my excess cash?" question. The end result is that by taking out the 401(k) loan and paying off the mortgage, you have less invested in the market than you otherwise would. If you're willing to accept lower likely returns in exchange for knowing you don't owe anyone anything, go right ahead. Just do so with the knowledge that the odds are against you with respect to this being a good idea from a net worth perspective.

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #9 on: May 21, 2015, 09:14:36 AM »
Actually OP would not be getting a 4.125% fixed return.  Paying yourself 4.125% interest is not the same as collecting 4.125% interest from someone else.  OP would be accepting a .5% fixed return (4.625-4.125).

The double taxation is not entirely a myth.  That 4.125% interest will be double taxed.  It's paid with taxable money  deposited into the 401k and will again be subject to taxation upon withdrawal.  Assume OP took a $100k loan, so in the first year the interest was ~$4k.  That $4k is taxed this year, deposited into the 401k, then taxed again upon withdrawal.  Additionally, as you mentioned, the foregone investment gains on the amount of the loan will not enjoy tax deferred growth.  Since OP is in a cash equivalent, the foregone gain is probably minimal for his/her case.  But assuming the stable value fund is paying 2%, that's another $2kish this year and compounded over a lifetime that will the OP will not get to enjoy tax deferrals on.

Furthermore, the investment interest is tax deductible already.  The 401k interest is not.  Based on this observation alone, the OP would need an effective tax rate below 10% to make these numbers work.  Adding that consideration to the other tax inefficiencies described above, this move would be suboptimal, IMO.
« Last Edit: May 21, 2015, 09:22:01 AM by BBub »

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #10 on: May 21, 2015, 09:17:06 AM »
The double taxation is a myth. You're not being taxed any more by doing this than you would be otherwise. You would repay the 401(k) loan with after-tax funds just like you're repaying your current loan with after-tax funds. Nothing is changing on that side of equation. Within the 401(k), the treatment of the interest is no different than if you loaned money to a third party (aka you bought a bond). In effect, the OP is proposing to do exactly this with their 401(k): buy the loan from the bank and collect interest on it.

This is exactly right.

Quote
So the question is whether buying that loan is a good investment. Sure, you won't be paying interest to the bank anymore, and you'll be increasing the value of your 401(k) as you make payments. But you have to remember that the amount you loaned out is no longer invested in index funds, so you're deciding to accept a fixed return of 4.25% on that money rather than a likely higher return from the market.

This would be right if the OP were using this money to invest in index funds.  But he/she isn't; that money is currently invested in a stable value fund.  I fully support investigating whether the OP would be better off in index funds instead of the stable value, and that's an interesting question.  But it's not what the OP is asking.  So it comes back to my last comment, which is that you just need to compare the cost of the mortgage with the return of the stable value fund.

If we're bringing other factors into the mix, beyond whether the OP should be invested in the high-fee equity options in their 401(k), then I think the biggest issue is liquidity vs. benefit.  By that I mean that the benefit on relatively small amounts is small: 5000 * (4.625 - rate on stable value fund) is maybe $200.  On large amounts, it could be significant: $100,000 * rate difference could be $4000-$5000 per year.  But it then exposes you to liquidity risk: if you lost your job, you'd have to pay back the 401k loan immediately, and if you didn't have the liquid funds to do so you'd pay taxes and fees.  So, the liquidity vs. benefit question gets my vote for the most important.

Philociraptor

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Re: The exact math behind using 401k loan to pay down debt
« Reply #11 on: May 21, 2015, 09:17:56 AM »
It looks like you got a good answer from your thread on the Bogleheads forum.

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #12 on: May 21, 2015, 09:21:59 AM »
Actually OP would not be getting a 4.125% fixed return.  Paying yourself 4.125% interest is not the same as collecting 4.125% interest from someone else.  OP would be accepting a .5% fixed return (4.625-4.125).

This is utterly wrong, see my above comments for an explanation why.

Quote
The double taxation is not entirely a myth.  That 4.125% interest will be double taxed.  It's paid with taxable money  deposited into the 401k and will again be subject to taxation upon withdrawal.  Assume OP took a $100k loan, so in the first year the interest was ~$4k.  That $4k is taxed this year, deposited into the 401k, then taxed again upon withdrawal. 

Well.. this is technically true.  But depending on the individual tax situation it could be positive, negative or neutral.  Sure, the $4k must be paid with after tax income.  But it is then placed in a tax-deferred account, where upon withdrawal it will be taxed at ordinary income rates.  In contrast, investing that $4k in a taxable account would also be using after tax income, but would pay investment taxes as appropriate (anything from 0% capital gains to ordinary income tax rates, depending on what it was invested in and when the gains were realized).  So whether this would be beneficial or not depends on the particular investments and timeframes. 

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #13 on: May 21, 2015, 09:34:49 AM »
Actually OP would not be getting a 4.125% fixed return.  Paying yourself 4.125% interest is not the same as collecting 4.125% interest from someone else.  OP would be accepting a .5% fixed return (4.625-4.125).

This is utterly wrong, see my above comments for an explanation why.

How is paying yourself 4% the same as getting paid 4% from a bond?  I could pull money out of my savings account today & pay it back plus interest for x yrs, and I haven't made a cent.  I've just saved more.  Since I forewent interest on that money for x yrs I actually lost a little.  Now, add in that I get double taxed on the extra interest and the situation is worsened further. 

Quote
Bbub
The double taxation is not entirely a myth.  That 4.125% interest will be double taxed.  It's paid with taxable money  deposited into the 401k and will again be subject to taxation upon withdrawal.  Assume OP took a $100k loan, so in the first year the interest was ~$4k.  That $4k is taxed this year, deposited into the 401k, then taxed again upon withdrawal. 
Quote
Beltim
Well.. this is technically true.  But depending on the individual tax situation it could be positive, negative or neutral.  Sure, the $4k must be paid with after tax income.  But it is then placed in a tax-deferred account, where upon withdrawal it will be taxed at ordinary income rates.  In contrast, investing that $4k in a taxable account would also be using after tax income, but would pay investment taxes as appropriate (anything from 0% capital gains to ordinary income tax rates, depending on what it was invested in and when the gains were realized).  So whether this would be beneficial or not depends on the particular investments and timeframes. 

By investing the $4k in a taxable account that $4k principal would never again be subject to taxation and the gains could be taxed more favorably than ordinary income with minimal effort.  Putting the $4k back into the 401k would subject that $4k plus gains to double taxation at ordinary income levels.  Guaranteed.

**also, look back up at my first post.  I added in another consideration:
Furthermore, the investment interest is tax deductible already.  The 401k interest is not.  Based on this observation alone, the OP would need an effective tax rate below 10% to make these numbers work.  Adding that consideration to the other tax inefficiencies described above, this move would be suboptimal, IMO.
« Last Edit: May 21, 2015, 09:38:45 AM by BBub »

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #14 on: May 21, 2015, 09:40:36 AM »
OP would be accepting a .5% fixed return (4.625-4.125).

This is utterly wrong, see my above comments for an explanation why.

How is paying yourself 4% the same as getting paid 4% from a bond?  I could pull money out of my savings account today & pay it back plus interest for x yrs, and I haven't made a cent.  I've just saved more.  Since I forewent interest on that money for x yrs I actually lost a little.  Now, add in that I get double taxed on the extra interest and the situation is worsened further. 

That's not the part I highlighted.  I've deleted anything extraneous.  The 401k interest rate is totally, completely irrelevant to the discussion of the return earned on the 401k loan.

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #15 on: May 21, 2015, 09:45:15 AM »
The 401k interest rate is entirely relevant because that interest is subject to double taxation.
« Last Edit: May 21, 2015, 09:47:27 AM by BBub »

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #16 on: May 21, 2015, 09:48:14 AM »

Quote
Bbub
The double taxation is not entirely a myth.  That 4.125% interest will be double taxed.  It's paid with taxable money  deposited into the 401k and will again be subject to taxation upon withdrawal.  Assume OP took a $100k loan, so in the first year the interest was ~$4k.  That $4k is taxed this year, deposited into the 401k, then taxed again upon withdrawal. 
Quote
Beltim
Well.. this is technically true.  But depending on the individual tax situation it could be positive, negative or neutral.  Sure, the $4k must be paid with after tax income.  But it is then placed in a tax-deferred account, where upon withdrawal it will be taxed at ordinary income rates.  In contrast, investing that $4k in a taxable account would also be using after tax income, but would pay investment taxes as appropriate (anything from 0% capital gains to ordinary income tax rates, depending on what it was invested in and when the gains were realized).  So whether this would be beneficial or not depends on the particular investments and timeframes. 

By investing the $4k in a taxable account that $4k principal would never again be subject to taxation and the gains could be taxed more favorably than ordinary income with minimal effort.  Putting the $4k back into the 401k would subject that $4k plus gains to double taxation at ordinary income levels.  Guaranteed.

Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #17 on: May 21, 2015, 09:50:33 AM »
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

How could it be good?  To be taxed twice on the same money at ordinary income rates.  Please explain how that could ever be good, assuming the current tax laws.

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #18 on: May 21, 2015, 09:50:54 AM »
The 401k interest rate is entirely relevant because that interest is subject to double taxation.

Are you deliberately ignoring my words?

The 401k interest rate is totally, completely irrelevant to the discussion of the return earned on the 401k loan.

You said the following incorrect statement:
Actually OP would not be getting a 4.125% fixed return. OP would be accepting a .5% fixed return (4.625-4.125).

This is wrong.

Edit: for hopefully an easier to see example of why this calculation is wrong, consider:  Let's say I have $100, and will give you the interest received from that $100.  I have an awesome investment that returns 10% every year, and so I give you $10 this year.  Your marginal tax rate is, say, 15%.  What is your return?

Your math above would suggest the answer is 10% - 15%, so by your math you'd lose 5%.  This is obviously wrong.  You're comparing two fractions with different denominators.
« Last Edit: May 21, 2015, 09:59:04 AM by beltim »

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #19 on: May 21, 2015, 09:53:31 AM »
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

How could it be good?  To be taxed twice on the same amount of money at ordinary income rates.  Please explain how that could ever be good, assuming the current tax laws.

Good question!  The easiest example is if your retirement income is not taxable, then you'll owe $0 on withdrawals from your 401k. 

If you had invested that $4k in a taxable account, and ever had to pay taxes on capital gains or dividends, then it would have been good for you to have put that after-tax money in your 401k.

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #20 on: May 21, 2015, 10:32:19 AM »
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

How could it be good?  To be taxed twice on the same amount of money at ordinary income rates.  Please explain how that could ever be good, assuming the current tax laws.
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

How could it be good?  To be taxed twice on the same amount of money at ordinary income rates.  Please explain how that could ever be good, assuming the current tax laws.

Good question!  The easiest example is if your retirement income is not taxable, then you'll owe $0 on withdrawals from your 401k. 

If you had invested that $4k in a taxable account, and ever had to pay taxes on capital gains or dividends, then it would have been good for you to have put that after-tax money in your 401k.

Good question!  The easiest example is if your retirement income is not taxable, then you'll owe $0 on withdrawals from your 401k. 

If you had invested that $4k in a taxable account, and ever had to pay taxes on capital gains or dividends, then it would have been good for you to have put that after-tax money in your 401k.

If you are in a 0% ordinary income tax bracket, you would also pay 0% on cap gains and dividends.  I would classify this example as neutral, but not good.  I'm inclined to lean slightly towards bad because a taxable acct provides more more control and flexibility w/ taxes, but I'll concede and give it a neutral.

I'll save you the trouble: There isn't a situation where being subject to double taxation at ordinary rates is good.


BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #21 on: May 21, 2015, 10:36:10 AM »
No I'm not ignoring your words. 

What is your counterpoint to my assertion that the 401k loan interest rate is entirely relevant since it's subject to double taxation?   I truly want to know why you think that is "totally, completely irrelevant".

You said the following incorrect statement:
Actually OP would not be getting a 4.125% fixed return. OP would be accepting a .5% fixed return (4.625-4.125).

This is wrong.

Edit: for hopefully an easier to see example of why this calculation is wrong, consider:  Let's say I have $100, and will give you the interest received from that $100.  I have an awesome investment that returns 10% every year, and so I give you $10 this year.  Your marginal tax rate is, say, 15%.  What is your return?

Your math above would suggest the answer is 10% - 15%, so by your math you'd lose 5%.  This is obviously wrong.  You're comparing two fractions with different denominators.

Yes, but the OP didn't mention an awesome investment returning 10%.  The OP had a tax deductible loan at 4.65%. The situation, as OP described, would actually be much worse than my above statement of .5% because I didn't factor in the foregone gains on stable value or the negative tax consequences associated with taking out a 401k loan subject to double taxation on the interest to pay off a tax deductible investment loan.


beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #22 on: May 21, 2015, 10:36:56 AM »
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

How could it be good?  To be taxed twice on the same amount of money at ordinary income rates.  Please explain how that could ever be good, assuming the current tax laws.
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

How could it be good?  To be taxed twice on the same amount of money at ordinary income rates.  Please explain how that could ever be good, assuming the current tax laws.

Good question!  The easiest example is if your retirement income is not taxable, then you'll owe $0 on withdrawals from your 401k. 

If you had invested that $4k in a taxable account, and ever had to pay taxes on capital gains or dividends, then it would have been good for you to have put that after-tax money in your 401k.

Good question!  The easiest example is if your retirement income is not taxable, then you'll owe $0 on withdrawals from your 401k. 

If you had invested that $4k in a taxable account, and ever had to pay taxes on capital gains or dividends, then it would have been good for you to have put that after-tax money in your 401k.

If you are in a 0% ordinary income tax bracket, you would also pay 0% on cap gains and dividends.  I would classify this example as neutral, but not good.  I'm inclined to lean slightly towards bad because a taxable acct provides more more control and flexibility w/ taxes, but I'll concede and give it a neutral.

I'll save you the trouble: There isn't a situation where being subject to double taxation at ordinary rates is good.

Please, please read what I said.  Just because you're in a 0% bracket in retirement doesn't mean you were in a 0% cap gains bracket during your working years. 

forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #23 on: May 21, 2015, 10:38:29 AM »
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

So if you are not in the 0% bracket for your income (i.e. exemptions plus deductions exceed income), it's double taxation.

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #24 on: May 21, 2015, 10:40:56 AM »
No I'm not ignoring your words. 

What is your counterpoint to my assertion that the 401k loan interest rate is entirely relevant since it's subject to double taxation?   I truly want to know why you think that is "totally, completely irrelevant".

What is the cost of the loan to the OP?  You're subtracting the 401k interest from the mortgage return.  But the OP KEEPS THAT MONEY.  It's ridiculous to subtract that as a cost. 

If you want to figure out the opportunity cost of putting that money into the 401k instead of a taxable account, that's fine and it's what we're doing in the parallel conversation.  But subtracting the whole amount makes no sense whatsoever.

seattlecyclone

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Re: The exact math behind using 401k loan to pay down debt
« Reply #25 on: May 21, 2015, 10:44:19 AM »
BBub, suppose we lived in a world where you were allowed to loan your 401(k) money to others, but not to yourself. You want to pay off your higher-rate debt, and your friend is willing to loan you the money out of her 401(k) at a lower rate. You take her up on her offer, she makes some interest off of the deal (which she will eventually have to pay tax on), and you pay less interest than on your current loan. You have another friend who wants to borrow money, so you loan him some of it and collect interest in your own 401(k), which you will eventually have to pay tax on.

Is this "double taxation?" If so, why? Nobody is paying any more tax in their 401(k) than if they invested in stocks that returned the same amount as the loan interest. Nobody is paying any more tax out of their paycheck than if they borrowed money from a non-401(k) source.

If this scenario isn't "double taxation," how exactly does it differ from the situation where you loan yourself money out of your 401(k)? In both scenarios, one person is paying off a debt out of post-tax funds and one person is receiving interest in a tax-deferred account.

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #26 on: May 21, 2015, 10:45:26 AM »
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.

So if you are not in the 0% bracket for your income (i.e. exemptions plus deductions exceed income), it's double taxation.

That $4k will be "double taxed" regardless of whether it's put in the 401k or not.  Either ordinary income + ordinary income (tax deferred), or ordinary income + capital gains/dividends (not tax deferred).

The first time I read your earlier comment I thought you were talking about double taxation of the 401k loan I misread it.

forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #27 on: May 21, 2015, 10:46:38 AM »
I had no idea that this seemingly boring topic would get so many posts in just one day. :)

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #28 on: May 21, 2015, 10:48:27 AM »
I had no idea that this seemingly boring topic would get so many posts in just one day. :)


forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #29 on: May 21, 2015, 10:53:37 AM »
I had no idea that this seemingly boring topic would get so many posts in just one day. :)



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Re: The exact math behind using 401k loan to pay down debt
« Reply #30 on: May 21, 2015, 11:08:26 AM »
Are there any other considerations I am missing?

For me, the issue would be the opportunity cost. You can use the funds from the 401k loan for anything - so is paying down (already historically low rate) mortgages the best use of the funds? You could get a higher return with more liquidity by investing that money in your taxable brokerage account. Or, if your allocation is light in real estate, you could use it as the down payment for another rental property.

brooklynguy

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Re: The exact math behind using 401k loan to pay down debt
« Reply #31 on: May 21, 2015, 11:12:22 AM »
I had no idea that this seemingly boring topic would get so many posts in just one day. :)

Normal people would say the same thing about every topic in this forum.

Yet here I sit, spectating in this thread on the intricacies of 401(k) loans as if it were the Super Bowl.

Look around you, forummm.  We are nerds.  We are all nerds.

forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #32 on: May 21, 2015, 11:17:57 AM »
I had no idea that this seemingly boring topic would get so many posts in just one day. :)

Normal people would say the same thing about every topic in this forum.

Yet here I sit, spectating in this thread on the intricacies of 401(k) loans as if it were the Super Bowl.

Look around you, forummm.  We are nerds.  We are all nerds.

We are all nerds. And that's why I'm here. But a lot of these threads get 5 or 10 posts the first day. This has 31 in a few hours.

brooklynguy

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Re: The exact math behind using 401k loan to pay down debt
« Reply #33 on: May 21, 2015, 11:20:59 AM »
We are all nerds. And that's why I'm here. But a lot of these threads get 5 or 10 posts the first day. This has 31 in a few hours.

That's because this thread just happened to become the venue of a nerd-off.

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #34 on: May 21, 2015, 11:30:27 AM »
I'll save you the trouble: There isn't a situation where being subject to double taxation at ordinary rates is good.

Let me introduce you to Al.  Al is in the 25% tax bracket and lives in the halcyon days when a Roth IRA was a Roth IRA, a traditional IRA was a traditional IRA, and there was no conversion between the two.  Al was single, covered by a 401k at work, and made too much money to deduct traditional IRA contributions or to contribute to a Roth.  Should Al invest in a taxable account or a non-deductible IRA?

The answer is complicated and depends on the investment, Al's future earnings, and Al's taxes in retirement.  But there are many cases where Al would be better off putting money in the non-deductible IRA.  For example:

Al has decided that this year's contribution of $4000 (after tax) would go into a corporate bond fund in accordance with his asset allocation plan.  He does a quick calculation to see whether he should put the money in a nondeductible IRA or a taxable account.  In a nondeductible IRA, the $4000 would grow tax-deferred would withdrawals taxes at ordinary income rates in retirement.  Al estimates that his bond fund will return 5% annually, and plans to withdraw the whole amount in 10 years, when he will be retired, and have an effective tax rate of 5%.  Al calculates that his after-tax amount in retirement will be:
$4000 * (1.05) ^ 10 * (1 - 0.05) = $6189.80
In contrast, in a taxable account, the interest Al receives each year is taxable at his marginal tax rate.  His after tax amount received from the $4k investment is:
$4000 * (1 + .05*.75) ^ 9 * (1 + .05 * .95) = $5835.89

The nondeductible IRA (directly analogous to the OP's situation) is better by $353.91!

Blonde Lawyer

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Re: The exact math behind using 401k loan to pay down debt
« Reply #35 on: May 21, 2015, 11:43:22 AM »
Here has how the double taxation issue has been explained to me.  It is not really a double taxation situation because you are removing taxes for a third situation where you would normally pay them.

Let's say I want new counter tops.  If I pay for them from my checking account, the money in my checking account came from my salary and was taxed.  I would be buying my counters with after tax dollars.  I didn't touch my 401k.

If I used money from my 401k, I'm using tax-free dollars to buy my counter tops.  I'm paying taxes on the money that goes back in because I would have used after tax dollars for my counter tops otherwise.  If I took out a home depot loan for the counter tops, I would be using after tax money to pay off that loan.  It is basically the same thing.

SanDiegoFIRE

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Re: The exact math behind using 401k loan to pay down debt
« Reply #36 on: May 21, 2015, 12:11:36 PM »
Thanks to all who responded

It sounds like I should take the loan and pay down debt instead of keeping it in a stable value fund.

We already have equity index investments in other tax deferred and taxable accounts, I am simply trying to optimize this very specific stable value part of our asset allocation

rmendpara

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Re: The exact math behind using 401k loan to pay down debt
« Reply #37 on: May 21, 2015, 12:18:23 PM »
would like some opinions on this please

I currently have a sizable 401k that is entirely invested in a (low-cost) stable value fund (think short term bonds).  The equity investment funds available in the 401k are all high fee (>1%) with no index options, so I park the balance in the low fee stable value and use it as the cash/short-term bond portion of our asset allocation.

The interest rate on a 401k loan is 4.125%.  Taking a loan does not affect ability to contribute to 401k, which I max every year due to being in highest tax bracket.  My job is stable and I have no plans to leave it in the near future.  If I were to get laid off I would receive a huge severance package as well as deferred comp that vests immediately, so I would easily be able to pay off any 401k loan balance and have a big amount left over.

We have various fixed rate mortgages on investment properties, the highest being 4.625%.  We also have many taxable accounts with large balances fully invested in equity index funds.  Given the current 0% rate environment, I try to keep as little cash as possible, except in the 401k due to the lack of low cost investment options.

The question I have is, does it make sense to take a loan on the 401k at 4.125% and use proceeds to pay down the highest rate (4.625%) mortgage?  I figured that since the 4.125% 401k loan interest would be paid to myself, using loan proceeds to pay off higher rate debt would make sense since I have no plans to invest the 401k balance in anything other than cash-like equivalents, and have no concerns about ability to repay the loan if my employment situation were to change.

Are there any other considerations I am missing?  One thought was that the interest I pay myself which accrues in the 401k account would be paid with after-tax dollars, but would then again be taxed upon eventual withdrawal - is this correct?

Thanks in advance

The "interest rate" on the 401k loan is irrelevant. In most 401k plans, this "interest" is fully repaid into the 401k. So, effectively, you are paying yourself from your checking out into your 401k at some amount... 4.125% of what you withdraw from the 401k in this case.

In order to determine if this is good/bad, you have to look at it from a Net Worth perspective... meaning, "how does my overall asset and liability picture change as a result of this."

To simplify, let's assume this is a 1 yr loan of $10,000 from the 401k (you can change the amounts, but the point will be the same).

Your current situation:
- some income level at a 25% marginal total tax rate
- 10k 401k "loan" @ 4.125%
- existing mortgage @ 4.625%, let's call it 200k outstanding (the amount is only relevant to calculate your net of income tax mortgage rate, because it will change every year if you decide to repeat this)
- 80k gross taxable income (net of all pre-tax deductions... HSA, 401k ,whatever)

Before we get started, let's clarify that the "net" mortgage rate will be different for everyone. For this example, you can deduct ~9.25k as a mortgage interest deduction... assuming you itemize. Note that this benefit will be gone before the mortgage is paid off, because the std deduction will be higher once the mortgage interest reaches ~6k/yr. So, the tax savings in this given year will be 9.25k - 6.2k (std deduction for single status), so a net tax savings of 3.05 x .25 = $762.50 when you file taxes. In the current year, that means you are effectively paying $8,487.50 in mortgage interest after tax... or an effective net of tax mortgage rate of 4.24375%. Some people mistakenly think the entire amount is a deduction... technically, it is, but we all get the std deduction anyway... so it's most accurate to only consider the marginal benefit over the std deduction when calculating your net of income tax mortgage interest rate.

Afterwards, you earn money on your 80k pre-tax salary. Whether you had a loan outstanding to yourself or not, you would pay the same amount of taxes here. So, it doesn't matter. What effectively changes is that you will accelerate paydown on a net of tax mortgage @ 4.24375% (above). Whether the cash is coming out of your 401k or not doesn't really matter. If you prefer to lock in a return of 4.125% into your 401k for the 10k, then so be it, but you are just transferring the money in your checking account to your 401k. Deduct from checking, add to 401k. Net worth is flat from the "401k loan" payment alone!

Of course, there are usually fees associated with taking out the loan, and also the case of whether or not you want to accelerate payment on a 4.24375% mortgage debt (4.625% nominal rate). That's a different story entirely.

In my view, the only reason to take out a "401k loan", is if you are short on cash and want to aggressively pay something off. A 4.625% mortgage is likely not a huge benefit. If you had credit card balances at 15%, then maybe you should consider it. Again, you're not "paying" anything to yourself. That rate of the 401k loan is just a transfer from checking to the 401k. The savings is by accelerating payoff of the debt itself. In the above example, the payer will save 10k @ 4.24375% (net of income tax mortgage rate) so ~$424.38 in the first year.

To clarify, that is the explicit savings. Other alternatives will make the decision very different, as it is based on many different assumptions:
- expected return in 401k investments
- expected return on taxable investments
- expected future interest rates
- other outstanding debts and related interest cost
- liquidity available from other sources
... and so on.

From a net perspective, and not including assumed rates of return, the only "savings" is the saving of mortgage interest. The rest is a decision on how aggressively you'd like to become debt free, and the expected return on your various investments and your liquidity costs.

Short answer: You only save the mortgage interest. The rest is paid from yourself... to yourself (from checking account cash to 401k). You'll have to consider the opportunity costs separately... as that is a very different and highly judgmental process.

Hope that helps.
« Last Edit: May 21, 2015, 12:21:29 PM by rmendpara »

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #38 on: May 21, 2015, 12:23:09 PM »

What is the cost of the loan to the OP?  You're subtracting the 401k interest from the mortgage return.  But the OP KEEPS THAT MONEY.  It's ridiculous to subtract that as a cost. 

If you want to figure out the opportunity cost of putting that money into the 401k instead of a taxable account, that's fine and it's what we're doing in the parallel conversation.  But subtracting the whole amount makes no sense whatsoever.

Got it.  I concede that subtracting the 4.125 alone of no consequence all else being equal.  However, all else is not equal in this situation. The 4.125 is double taxed - we've established that.  The 4.625 investment interest that OP is considering refinancing is tax deductible.  Then there's the opportunity cost on the foregone stable value investment.  So, the correct formula would be

Loan Balance*[4.625*(1-t) - (r)-(4.125*(t)^n], then run again for n+1, +2, and so on for the number of years on the 401k loan.

t = tax rate
r = rate of return on investments, or stable value
n = tims

Assuming a tax rate of 25% and a stable value of return, OP would gain 0.44% with this maneuver - as expected, slightly worse than my initial handwave of 0.5%. However, this figure still doesn't take into account the back end tax on the $4k interest.

That $4k will be "double taxed" regardless of whether it's put in the 401k or not.  Either ordinary income + ordinary income (tax deferred), or ordinary income + capital gains/dividends (not tax deferred).

The first time I read your earlier comment I thought you were talking about double taxation of the 401k loan I misread it.

No it won't be double taxed regardless if you invest in a taxable acct, the $4k is only taxed once.  Gains may be subject to additional tax, but the $4k is not.  The 401k situation causes that $4k to be double taxed plus ordinary income tax applies to the gains.

We are all nerds. And that's why I'm here.

That's because this thread just happened to become the venue of a nerd-off.

Look around you, forummm.  We are nerds.  We are all nerds.


Possibly the most accurate statements I've seen all day.

Let me introduce you to Al.  Al is in the 25% tax bracket and lives in the halcyon days when a Roth IRA was a Roth IRA, a traditional IRA was a traditional IRA, and there was no conversion between the two.  Al was single, covered by a 401k at work, and made too much money to deduct traditional IRA contributions or to contribute to a Roth.  Should Al invest in a taxable account or a non-deductible IRA?

The answer is complicated and depends on the investment, Al's future earnings, and Al's taxes in retirement.  But there are many cases where Al would be better off putting money in the non-deductible IRA.  For example:

Al has decided that this year's contribution of $4000 (after tax) would go into a corporate bond fund in accordance with his asset allocation plan.  He does a quick calculation to see whether he should put the money in a nondeductible IRA or a taxable account.  In a nondeductible IRA, the $4000 would grow tax-deferred would withdrawals taxes at ordinary income rates in retirement.  Al estimates that his bond fund will return 5% annually, and plans to withdraw the whole amount in 10 years, when he will be retired, and have an effective tax rate of 5%.  Al calculates that his after-tax amount in retirement will be:
$4000 * (1.05) ^ 10 * (1 - 0.05) = $6189.80
In contrast, in a taxable account, the interest Al receives each year is taxable at his marginal tax rate.  His after tax amount received from the $4k investment is:
$4000 * (1 + .05*.75) ^ 9 * (1 + .05 * .95) = $5835.89

The nondeductible IRA (directly analogous to the OP's situation) is better by $353.91!

I have many issues with the Al example.  First, I explicitly asked for a case using current tax laws.  You can check the post.  That means not pretending like we are in the "halcyon days" before x,y and z tax laws were changed..  Further more, unlike AL, the OP he never once mentioned considering an investment returning 5%.  He mentioned a stable value fund paying presumably much less.

Here has how the double taxation issue has been explained to me.  It is not really a double taxation situation because you are removing taxes for a third situation where you would normally pay them.


 The Op asked about refinancing investment debt on which the interest is nontaxable.  His "third situation" is not one where he would be normally paying taxes.

Gone Fishing

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Re: The exact math behind using 401k loan to pay down debt
« Reply #39 on: May 21, 2015, 12:25:11 PM »
Can we pause the show while I make popcorn and go to the bathroom?



Gone Fishing

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Re: The exact math behind using 401k loan to pay down debt
« Reply #40 on: May 21, 2015, 12:27:23 PM »
Thanks to all who responded

It sounds like I should take the loan and pay down debt instead of keeping it in a stable value fund.

We already have equity index investments in other tax deferred and taxable accounts, I am simply trying to optimize this very specific stable value part of our asset allocation


What is the long term expected return on your stable value fund?

What is the expected tax rate on your 401(k) withdrawals?
« Last Edit: May 21, 2015, 12:28:55 PM by So Close »

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #41 on: May 21, 2015, 12:29:27 PM »
Can we pause the show while I make popcorn and go to the bathroom?

Can you get me a drink while you're up?

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #42 on: May 21, 2015, 12:30:15 PM »
Thanks to all who responded

It sounds like I should take the loan and pay down debt instead of keeping it in a stable value fund.

We already have equity index investments in other tax deferred and taxable accounts, I am simply trying to optimize this very specific stable value part of our asset allocation

If you provide the following info, I can run the calcs using the exact formula:

1. Loan amount
2. Your tax rate
3. Stable value return %
4. Number of  years to pay back the loan
5. If possible, estimated tax rate in retirement.
6. Number of years to retirement.

Loan Balance*[4.625*(1-t) - (r)-(4.125*(t)^n]. then run again for n+1, +2, and so on for the number of years on the 401k loan.

Then we can calculate the FV of your total interest expense (the interest subject to double tax that you're putting back into your 401k), asssuming the number of years to retirement and the stable value ROR.  Then multiply that amount by your anticipated post retirement tax rate to determine the total cost of this maneuver.

Does this make sense?  Would any of you fellow nerds out there like to peer-review my methodology here?

« Last Edit: May 21, 2015, 12:32:22 PM by BBub »

Gone Fishing

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Re: The exact math behind using 401k loan to pay down debt
« Reply #43 on: May 21, 2015, 12:33:24 PM »
Can we pause the show while I make popcorn and go to the bathroom?

Can you get me a drink while you're up?

Sure! I've been meaning to try out my new Kuerig Kold;)

BBub

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Re: The exact math behind using 401k loan to pay down debt
« Reply #44 on: May 21, 2015, 12:35:46 PM »
Can we pause the show while I make popcorn and go to the bathroom?

Can you get me a drink while you're up?

Sure! I've been meaning to try out my new Kuerig Kold;)

Eww, you have a kuerig.  Have you run the calcs on the long term cost of that thing?  :-) jk I'm not going there.

forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #45 on: May 21, 2015, 12:36:02 PM »
I'll save you the trouble: There isn't a situation where being subject to double taxation at ordinary rates is good.

Let me introduce you to Al. 

Hi Al! Welcome to this nerd-off object lesson!

forummm

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Re: The exact math behind using 401k loan to pay down debt
« Reply #46 on: May 21, 2015, 12:36:52 PM »
Can we pause the show while I make popcorn and go to the bathroom?

Can you get me a drink while you're up?

Sure! I've been meaning to try out my new Kuerig Kold;)

Water's more mustachian.

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #47 on: May 21, 2015, 12:37:19 PM »

What is the cost of the loan to the OP?  You're subtracting the 401k interest from the mortgage return.  But the OP KEEPS THAT MONEY.  It's ridiculous to subtract that as a cost. 

If you want to figure out the opportunity cost of putting that money into the 401k instead of a taxable account, that's fine and it's what we're doing in the parallel conversation.  But subtracting the whole amount makes no sense whatsoever.

Got it.  I concede that subtracting the 4.125 alone of no consequence all else being equal. 

Good!

Quote
However, all else is not equal in this situation. The 4.125 is double taxed - we've established that.  The 4.625 investment interest that OP is considering refinancing is tax deductible.  Then there's the opportunity cost on the foregone stable value investment. 

Agreed that not else is equal.

Quote
So, the correct formula would be

Loan Balance*[4.625*(1-t) - (r)-(4.125*(t)^n], then run again for n+1, +2, and so on for the number of years on the 401k loan.

t = tax rate
r = rate of return on investments, or stable value
n = tims

Assuming a tax rate of 25% and a stable value of return, OP would gain 0.44% with this maneuver - as expected, slightly worse than my initial handwave of 0.5%. However, this figure still doesn't take into account the back end tax on the $4k interest.

No, this equation makes no sense.  Specifically, the (4.125*(t)^n term makes no sense.  That term would be the amount of taxes paid each year on the money you put into the 401k in excess of your original contributions (i.e. the "interest" on the 401k loan).  But that money is taxed this year regardless of what you use it for.

CorpRaider

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Re: The exact math behind using 401k loan to pay down debt
« Reply #48 on: May 21, 2015, 12:39:23 PM »
I stopped reading after Seattle and Belt correctly esplained the analysis the third time, so I may have missed this coming up in the discussion, but OP you should compare your after tax rate on the mortgage (I assume they are deductible/offsetting rental income) to the expected return on the foregone investment return on the principle you are withdrawing from 401(k).  Almost exactly the same as decision to pay down mortgage or invest as one of these smart cookies has already stated. 
« Last Edit: May 21, 2015, 12:54:16 PM by CorpRaider »

beltim

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Re: The exact math behind using 401k loan to pay down debt
« Reply #49 on: May 21, 2015, 12:42:53 PM »
I have many issues with the Al example.  First, I explicitly asked for a case using current tax laws.  You can check the post.  That means not pretending like we are in the "halcyon days" before x,y and z tax laws were changed..  Further more, unlike AL, the OP he never once mentioned considering an investment returning 5%.  He mentioned a stable value fund paying presumably much less.

As for this, the math is exactly the same as the current situation.  Whether Al repays a 401k loan or elects to contribute to a non-deductible IRA, the math is exactly the same.

And you "explicitly said:"
Quote
There isn't a situation where being subject to double taxation at ordinary rates is good.

My example directly proves that your statement is false.  My statement - that:
Quote
Yes, the extra $4k in your example is taxable at ordinary income tax rates upon withdrawal.  I said that in my response.  Whether that's bad, good, or neutral depends on your individual tax circumstances.
still holds true.  There are examples where deferring taxes is worth paying ordinary income tax, and there are examples where not deferring taxes is better.