401k Loan for General Purpose and Primary Residence; In Service Withdrawals

[nico08]

My 401k plan has loans available for general purpose and for a primary residence. The rates on both of these loans is 3.25%. The repayment period for the general purpose loan is 12 to 60 months and the repayment period for the primary residence loan is 66 to 180 months.

Does loaning money from your 401k make economic sense? The interest rate of 3.25% sounds potentially attractive, but I thought I read somewhere that the interest repayment on this type of loan is not tax deductible like traditional mortgage interest. If so, then why would someone take a loan from their 401k if they would lose the tax deductibility of the interest? Also, if I took a loan from my 401k, then wouldn't I be losing the tax-deferred compounded growth effect that I benefit from with money in the 401k?

My 401k plan also has something called an in service withdrawal. This is a withdrawal type different from a hardship withdrawal and I believe that an in service withdrawal can be taken out for any reason. I believe that the amount representing the in service withdrawal can be transferred into an individual IRA. Assuming that the 401k plan that I am in provides a good selection of investment choices with low expense ratios, is there any reason I should consider an in service withdrawal?

Thank you for your insight.

 

[LOL!]

I think there are a lot of misconceptions about 401(k) loans. There are good things and bad things about them.

Major bad thing:
If you lose your job, then if you do not pay back the loan IN FULL shortly thereafter, the amount still outstanding is considered a withdrawal. This could cost you a 10% penalty and an income tax hit. Generally (but not always!), folks who need a 401(k) loan are already in a precarious financial position, so job loss is not good.

Minor bad thing:
While the loan principal you pay back is not double-taxed, the interest that you pay back is taxed twice. Since the interest is low nowadays, this is a negligible amount. Example: You pay $1000 a year in interest. You have to earn $1250, then pay $250 in taxes to get that $1000. When you withdraw that $1000 from the 401(k) (in retirement, say at age 65) you pay tax on that $1000 again.

There is usually an administrative fee of $50 to $100 a year that the 401(k) provider charges to service the loan.

You mentioned the disadvantage of losing tax-deferred growth. Yes, you are using some of your retirement funds now and not later in retirement.
You can miss out on tax-deferred compounding.

Sometimes if you have a 401(k) loan, I am told that you cannot continue contributions to your 401(k) plan. I do not believe that is the case for most plans, but be sure to check it out.

The in-service rollover is a great thing. Your idea to get to better, lower-expense ratio investments is good. The only disadvantage I see to that is that if you are doing the so-called "back-door Roth" because your income is too high, then you would not want a traditional IRA hanging around that would mess this up.

Here's another trick: Take out a 401(k) loan and use the money to fund a 529 plan. That way, not only are the gains tax-deferred, they become tax-free. If you are a parent that is going to pay for college anyways, this can save you money. This is especially true if your 401(k) funds have expense ratios of 1.5% or more and your 529 plan has funds with expense ratios under 0.4%. Add a state income tax benefit and you are golden.

Many folks claim a 401(k) loan is a hassle. We have such a loan and it is easy to get and trivial to pay back since the payments come right out of your paycheck.

The interest you pay on your 401(k) loan is like taking money from your right pocket and putting it in your left pocket. Thus, the interest rate is not really the cost of the loan. The cost includes the ancillary fees, the extra tax you pay on the interest you pay back, and perhaps the loss of deferment. This cost can be practically zero.

Once again the major problem is job loss, but if you can pay back the loan immediately upon loss of your job and your numbers work out, I see no reason not to have a 401(k) loan. Just don't spend the loan money; invest it [conservatively] instead perhaps the same way it was invested in the first place.

 

[heikejohn]

The in-service rollover is a great thing. Your idea to get to better, lower-expense ratio investments is good. The only disadvantage I see to that is that if you are doing the so-called "back-door Roth" because your income is too high, then you would not want a traditional IRA hanging around that would mess this up.

How would I find out if my husbands plan offered this?

 

[LOL!]

Almost all plans allow in-service withdrawals and rollovers if the employee is age 59.5 and older. I would ask my husband to find out about his plan.

 

[jayc]

The general concept is building net worth via adding to your 401K. If you need a loan for 'general purpose and primary residence' then you are not LBYM and do not have a structured budget to save. You do not have any money set aside for emergency fund. Convincing yourself that this is a good idea is denial and you are headed the wrong way to FI.

If you are going to invest it, to me this is the same as investing in a mutual fund with a front end load of 3.25%.

 

[LOL!]

It is definitely not the same as a fund with a 3.25% front-end load. Our 401(k) loan will save us a few thousand dollars. If you would not like a free $2K to $3K, then you are not LBYM.

In fact, many folks have some 401(k) money in a stable value or money market fund paying a lower interest rate than 3.25%. The loan would allow your 401(k) to have a higher return than such investments without risk.

 

[jayc]

It is definitely not the same as a fund with a 3.25% front-end load. Our 401(k) loan will save us a few thousand dollars. If you would not like a free $2K to $3K, then you are not LBYM.

In fact, many folks have some 401(k) money in a stable value or money market fund paying a lower interest rate than 3.25%. The loan would allow your 401(k) to have a higher return than such investments without risk.

Assume $40K balance. Please confirm where the 3.25% ($325) goes. I borrow 10K for one year. I pay back $10,325. Does my 401K balance get credited for 10K plus $325? Are my investments earning interest/dividends on $30K or $40K for that year?

 

[Aeowyn]

I would not recommend a 401K loan. As mentioned, if you leave the job for any reason, the loan is due in full or it is considered and early withdrawal. If you can pay it back, great. But what if you leave the job due to a layoff - just when you really need the money, you've lost you're income stream. What if you leave the job because you become disabled - again just when you need the money. What if you leave because you die? You're leaving you're family in a bad place just when they're not emotionally in a spot to deal with it.

In service withdrawals: Even if you are less than 59 1/2 some withdrawals may be possible. You're pre-tax and Roth contributions can't be touched, but some plans allow for the company match and after-tax Traditional contributions to be taken out and rolled to an IRA.

 

[LOL!]

Your 401(k) balance becomes $10,325 plus $30K plus whatever the $30K earns as well.

So if you have a $40K 401(k) with $10K in a 1% MM fund and $30K in a stock fund and borrow $10K, you set the $30K left in your 401(k) to be 100% in that stock fund. You come out ahead.

Of course, the $325 comes from somewhere. You cannot just spend the $10K, you have to invest it somehow to get the $325 and the taxes you paid to get the $325.

If your 401(k) is crummy and you pay 2% expense ratios on your 401(k) funds like my spouse does, then the loan immediately saves you almost 2% in fees annually on the borrowed money. Of course, since you are paying back the loan from day one (it's not a balloon payment at the end of the term), you don't get the full 2% savings, but over a 4-year loan you get more than 2% savings.

 

[jayc]

Your 401(k) balance becomes $10,325 plus $30K plus whatever the $30K earns as well.

So if you have a $40K 401(k) with $10K in a 1% MM fund and $30K in a stock fund and borrow $10K, you set the $30K left in your 401(k) to be 100% in that stock fund. You come out ahead.

Of course, the $325 comes from somewhere. You cannot just spend the $10K, you have to invest it somehow to get the $325 and the taxes you paid to get the $325.

If your 401(k) is crummy and you pay 2% expense ratios on your 401(k) funds like my spouse does, then the loan immediately saves you almost 2% in fees annually on the borrowed money. Of course, since you are paying back the loan from day one (it's not a balloon payment at the end of the term), you don't get the full 2% savings, but over a 4-year loan you get more than 2% savings.

So there are opportunity costs on the $10K and you use 1% MM. If I was getting 4% across the board on my 401K then I should move the amount I want to borrow into a lower yielding investment (anything below the loan %) so the math will be favorable to justify the transaction. Then why stop with paying yourself a paltry 3.25%. Take 6.5% out of your left pocket and put in your right pocket to double your return.

IMO. Too many things that are assumed and can go wrong to make this a good thing to me. I would still only use it as a last resort. Thanks for the explanation.

 

[LOL!]

You are right you do not want to pay 6.5% to make 3.25%.

However, suppose my spouse's 401(k) plan invests in Fund X with an expense ratio of 0.25%, but her plan adds a 1.75% wrap fee. Further suppose I have a 529 plan for a kid who is going to college and that 529 plan also has Fund X but without the 1.75% wrap fee.

Since the gains in Fund X in the 529 plan are tax-free (it's like a Roth) while the gains in the 401(k) will be taxed when the money gets withdrawn in retirement, what are my savings by taking out a loan from the 401(k)'s Fund X and investing the money in the 529 plan's Fund X?

While at first glance it appears that it does not matter what interest rate you pay on your loan since you are paying it back to yourself, it does matter because you use after-tax money to pay that interest. Your savings from the loan have to exceed the taxes and fees paid.