401K Loan?

[rduell]

I did a search and didn't come up with anything on taking a loan out of your 401K. First of all, is this possible? Second, do you have to pay taxes or a penalty if you're paying yourself back?

We aren't seriously thinking of doing this. My husband had just mentioned the possibility.

[tinapbeana]

Re: 401K Loan?

I did a search and didn't come up with anything on taking a loan out of your 401K. First of all, is this possible? Second, do you have to pay taxes or a penalty if you're paying yourself back?

We aren't seriously thinking of doing this. My husband had just mentioned the possibility.

i believe the possibility of taking a loan is determined by which company manages your 401k. i had ML and they allowed taking a loan with no penalties and a 1 time fee. the interest i paid on the loan was paid to myself and put back into my 401k account.

[disneysteve]

Re: 401K Loan?

You can borrow from your 401K but it is a really bad idea and should be reserved for emergencies only as a last resort. There is no penalty for borrowing as long as you follow the loan guidelines.

You lose the growth the money would have had while you have it out of the account. And you repay pre-tax money with post-tax money. Then that money gets taxed again in retirement, so you end up paying taxes twice on the same funds. If you leave the company while you have an outstanding loan, you generally have to repay it right away which could be a problem if you don't have the money.

Many reasons why it isn't a good idea.

[sweeps]

Re: 401K Loan?

tina and steve are both right. Your employer determines whether you can borrow from your 401k, and if so, what the terms are. And as Steve points out, it should be reserved for emergency situations. You'll often here it's good to borrow from your 401k because "You're paying yourself back with interest." but that statement is simplistic and misleading.

[rduell]

Re: 401K Loan?

Thanks! I knew it was a bad idea, but couldn't clearly explain to him how it is that you get taxed twice. He has guys at work telling him exactly that ("you're paying yourself the interest"). I will print this out so he can hear it from someone other than me.

[tinapbeana]

Re: 401K Loan?

tina and steve are both right. Your employer determines whether you can borrow from your 401k, and if so, what the terms are. And as Steve points out, it should be reserved for emergency situations. You'll often here it's good to borrow from your 401k because "You're paying yourself back with interest." but that statement is simplistic and misleading.

i agree, it is simplistic. in my case, however, borrowing from my 401k allowed me to put a downpayment on my house, which was selling for 20% below appraised value. i hadn't planned on buying a house for another year or so, but this was an opportunity i didn't want to pass up.

[disneysteve]

Re: 401K Loan?

http://moneycentral.msn.com/articles/retire/basics/4714.asp

Here's one article explaining pros and cons of 401K loans.

[sweeps]

Re: 401K Loan?

in my case, however, borrowing from my 401k allowed me to put a downpayment on my house, which was selling for 20% below appraised value. i hadn't planned on buying a house for another year or so, but this was an opportunity i didn't want to pass up.

There are always exceptions. As Howie Mandel might say... You made a great deal.

[tinapbeana]

Re: 401K Loan?

There are always exceptions. As Howie Mandel might say... You made a great deal.

as long as he's saying it in his Bobbie voice!!! *g*

[rduell]

Re: 401K Loan?

http://moneycentral.msn.com/articles...asics/4714.asp

Here's one article explaining pros and cons of 401K loans.

Thanks Steve! I've printed that out. I don't know if he'll take the time to read it though. He doesn't have the interest in financial things that I do.

[pan2]

Re: 401K Loan?

You can borrow from your 401K but it is a really bad idea and should be reserved for emergencies only as a last resort. There is no penalty for borrowing as long as you follow the loan guidelines.

You lose the growth the money would have had while you have it out of the account. And you repay pre-tax money with post-tax money. Then that money gets taxed again in retirement, so you end up paying taxes twice on the same funds. If you leave the company while you have an outstanding loan, you generally have to repay it right away which could be a problem if you don't have the money.

Many reasons why it isn't a good idea.

Not that I dispute your underlying point, but the "the money gets taxed twice" argument is a bit simplistic. The very terse explanation for this is that the money you're borrowing is pre-tax dollars, but some examples would make this clearer.

Let's compare alternatives to borrowing from a 401k. One possibility would be never to have put the money into the 401k to begin with. (Living in the CA Bay Area this is an issue I've faced when deciding whether to save cash for a house or put the money into a 401k and borrow from it later if needed.)

To that end, let's consider two people A and B who, to keep very simple numbers, each earn $100K and pay 30% taxes. Suppose A contributes ALL of his salary to his 401K and B contributes NONE of his salary to his 401k. For simplicity I'll neglect the interest earned over the course of the year, although it turns out that to include this would actually further reduce the "penalty" of borrowing from the 401k. At the end of one year, the assets looks like:

A: $100K in his 401k
B: $70K cash

Now suppose each wants to make an important purchase of $70K. For B, it's simple, he just spends all of this cash. For A, he must borrow $70K from his 401K to be repaid later. Either way, after making the purchase, the situations look like:

A: $30K in his 401k (owes $70K back to himself)
B: $0 cash

Now consider the following year and suppose this year each earns $110K (I give them a raise only because I'm assuming A has no other cash on hand and he'll need a little extra to pay the interest on his loan. Assuming A is not dead broke, this would not be an issue.)

After taxes, each will take home $77K. Let's suppose that A has to pay back his loan at 5% and, for simplicity, the interest is compounded only annually. So A needs to pay $73500 into his 401k, leaving the end of year situation like so:

A: $103,500 in his 401k + $3500 cash
B: empty 401K + $77000 cash

So who's better off here, the guy who never put the money into his 401k or the guy who put in and then borrowed it back out? Well, to compare these two let's suppose that A is old enough to withdrawn from his 401k without penalty and let's suppose, to make things as bad as possible, that he still has to pay the high 30% tax rate on these distributions. If he clears out his 401k and pays 30% tax, the net cash looks like:

A: $75,950
B: $77,000

So A is still worse off than B, but not by much. In fact, the difference in their net assets ($1050) is exactly attributable to the fact that A could not deduct his $3500 interest payments and so these were made with after tax dollars. (Notice $3500 * 30% = $1050!) This is why I say the "taxed twice" argument is simplistic-- it's really only the twice-taxed interest payment that makes the difference.

I've also neglected two important facts that further close the gap between A and B. First, A had an additional $30K of pre-tax dollars which remained in his 401k even after he borrowed the $70k, since those initial 401k contributions were made with pre-tax dollars. Assuming a meager 5% return and not even bothering to compound the interest, after two years this gives A an additional $3k in his 401k. After withdrawing it and paying 30% taxes, he still ends up with $2100, more than the $1050 shortfall he suffered from paying back the interest with after-tax dollars. And the second important detail is that A may be able to withdraw from his 401k at less than 30% tax, effectively giving him even more net cash.

As a separate case, one could compare borrowing from a 401k vs borrowing from a bank. Again I believe the difference is much closer than the simplistic arguments might suggests. To tackle a couple of them: while your 401k money isn't earning interest for you if you borrow from it, you're instead *paying* interest to the bank if you borrow from them. At this point it comes down to a question of whether you think you can earn higher interest rates on your 401k investments than the bank charges you, which is certainly not a clear cut proposition. Then returning to the issue of "paying yourself back with after tax dollars", well you'll be paying back the exact same number of after tax dollars to the bank when you repay the loan principal. (And while it's true that the loan interest is tax-deductible, you'll eventually pay tax on the interest accrued in your 401k, so again it comes down to a rate comparison.)

In summary, I'm really not taking a for or against stand on 401k loans and I agree with the above comments that it really depends on the particulars of circumstance, but I do want to illustrate that some of the conventional wisdom against 401k loans is presented in a way that may overstate the case against them.

[disneysteve]

Re: 401K Loan?

pan2 - I think you raise some good points. though your examples are very unrealistic.

Here is an example comparing a 401K loan to a home equity loan.

http://www.mtgprofessor.com/A%20-%20Second%20Mortgages/second_mortgage_versus_401k_loan.htm

Here is one other site that gives a good pro/con breakdown.

http://www.401khelpcenter.com/loans.html

[pan2]

Re: 401K Loan?

steve, I actually agree completely with the explanation in the first link you posted. My point, and it was meant to be a very limited one, was simply that the "repaying yourself with after-tax dollars is like being taxed twice" argument is perhaps a misleading one. I note that the example you posted makes no mention of this argument.

As far as my numbers being unrealistic, you may be right-- I chose them mostly because it made the math very simple and doesn't really affect the underlying point. But as I mention above (and your article says essentially the same thing), "At this point it comes down to a question of whether you think you can earn higher interest rates on your 401k investments than the bank charges you, which is certainly not a clear cut proposition." I still maintain that this is really the fundamental issue from the point of view of maximizing your assets.

[rduell]

Re: 401K Loan?

Thanks to everyone!

I printed out what Steve posted earlier and DH did read it. After reading it he said he wanted to know mainly because he had had a discussion with our mechanic/friend/son's employer about borrowing from a 401K and the other guy had said that it was not true that you get taxed twice on it.

Whew! He has mentioned in the past about borrowing from his 401K to finish fixing up the house, but I have always resisted as much as possible. Just don't like the idea. I want that money to be put away and forgotten until retirement.

[disneysteve]

Re: 401K Loan?

He has mentioned in the past about borrowing from his 401K to finish fixing up the house, but I have always resisted as much as possible. Just don't like the idea. I want that money to be put away and forgotten until retirement.

I agree. I think it is called a "retirement" account for a reason. It is for retirement. That's why I generally feel it should be a last resort option when you need extra money. If you develop the mindset that your 401K is just a pool of money to be drawn from whenever you need to fix up the house or buy a new car or take a vacation, you'll probably be sorry when retirement rolls around.

pan2 - I think we agree. Ultimately, whether or not borrowing from a 401K is a good move financially depends on what other options you are comparing it to.