Overheard, (OK I’m bored, snoopy and have nothing to do anyway…) two girls talking. One said it is better to take out a loan against your 401K as when you pay it back you are paying yourself.
This got me to thinking. Since 401k is PRE-TAX and when you pay back the loan you are paying it back with AFTER TAX dollars. THEN when you turn 59 1/2 and take it out you pay tax on it again. (although hopefully at a lower rate)
Is this a right way of looking at it? So what does that mean in term of effective rate of interest if this is correct.
While the pay-yourself-interest idea sounds good at first blush, where it falls apart is that while you have the money out of your account, you’re not getting interest on it. And the interest rate on your 401K is effectively increased by the fact that it’s not taxed (yet). You know how compound interest is kind of amazing, and the higher the rate, the more amazing? The fact that your 401K compounds without tax is effectively like getting a rate that’s higher by 1/3.
When I worked in 401(k) administration, people would take out revolving loans from their plans all the time. What I mean is, they were allowed to have up to 2 loans outstanding at once, which they could pay off in full by writing a check at any time. Frequently employees would pay off an existing loan in order to be able to take out a new, bigger loan. Once they had built up their balances a bit more, they would do it again.
It totally defeats the purpose of having a 401(k), which is long-term tax deferment. Your being taxed twice and you’re hurting your earnings potential, as has already been mentioned.
Also, something no one has mentioned, if you lose your job you could be screwed. You generally have to pay the remaning balance back all at once, or you end up being taxed on it – not only normal income tax, but an additional 10% penalty tax (if you’re below retirement age).
I never could do the math, but it depends on your income tax bracket and your expected rate of return on your 401(k) (for the duration of your investment).
In the very long run, it’s better to leave it in your 401(k). If you can get a home equity loan (with tax deductible interest), that’s often a better option. However, I am not a financial planner – don’t rely on my advice in order to retire comforably.
It’s possible to take a loan from your 401(k) in a financially responsible manner. I’ve done it, and I never do anything irresponsible!
If you have other outstanding debt (usually a mortgage), the decision to pay off via a 401(k) loan is similar to the decision to pay off via cash on hand. If you think your investments will earn a higher return than your mortgage, leave the mortgage outstanding and invest your money. If you think the opposite, pay off the mortgage.
In general, over the long haul, you can earn a higher return via investing than the typical home mortgage rate. But at times (such as three years ago) financial markets become over-heated, and one can reasonably forecast crummy returns. Under those circumstances early pay-out makes sense.
However–you should NOT NOT NOT take out a 401(k) loan and blow it on a trip to Bermuda, or leverage it to increase other indebtedness. But of course nobody smart enough to post on this board would even consider such a thing–RIGHT?
Same with all other loans. How can this be a con? It’s a non-issue.
Mortgages, home equity and brokerage account margin loans are tax deductable, other loans aren’t. Obviously, if you qualify for one of these loans, it may be more benficial (but maybe not - depends on the details).
As for earnings, well, they have to come from somewhere! As a trade off, your interest isn’t contributing to the earnings of a bank. Depending on interest rates involved (bank loan vs. 401k loan vs. non-loan 401k earnings) it might be a wash, or maybe not.
Another irrelevant point. If you don’t have enough cash coming in every month to cover your expenses, you might have to cut back on your 401k contributions. This is true whatever kind of loan you have - car loan, mortgage, 401k loan, breast enhancement loan, or whatever.
OK, good point. The loan can be “called” with 90 days notice, so you better have options open to you to deal with this if it occurs.
Then they proceed with a table that assumes investment return is always higher than the loan rate. They assume investment rate of return of 11%, but loan interest rates from 6.3% to 9.5%. Why didn’t they show 11% or higher loan interest rate?
Also, the table with the big differences in return is with “suspend contributions during term of loan”. But as I mentioned above, suspending contributions is independent of what kind of loan you take out.
Bottom line:
If you have a house and have some equity, a home equity loan is probably the best deal, because interest is (usually) deductable. If you have a brokerage account with a stable portfolio, a margin loan might also be a good deal, again because it is (usually) deductable. But a 401k loan can be a good deal, depending on interest rates vs. expected rate of return on your 401k portfolio. In particular, if you have some of your 401k invested in money market funds, taking out a 401k loan in lieu of money markets can be a small win for your 401k.
But since the ORIGINAL money in a 401k was put their tax free when you replace it you are putting the money back with money you’ve been taxed on. THEN when you take it out again at say 59 1/2 you pay tax on it. So in effect aren’t you being double taxed.
I don’t get how that is irrelevent. Or am I looking at this wrong?
The tax status of the original money in the 401k is irrelevant. You need a loan, and you have two choices:
Go to a bank, get a loan
Go to your 401k administrator, get a loan
In both cases you are paying back the same amount of money (assuming similar loan terms and tax deductability), and in both cases the money you use to pay it back is after-tax. That is why the after-tax stuff is irrelevant - you’ll be paying with after-tax money anyway.
If you don’t need the money, but are taking out a 401k loan just so you can pay yourself interest, well, that’s dumb. But, then again, so is taking out a bank loan just so you can pay the bank interest…
