401k Loans

[rogerc1944]

On another thread, I pointed out that 401k loans were almost always a really bad idea. Such loans trigger double taxation (repaying the loan from pretax money with after tax money and then being taxed again when the funds are taken out during retirement). A couple of people didn't seem to understand this double taxation problem. Also, in the event of job loss, money owed on a 401k loan and not paid back could be considered a distribution. Not only would regular taxes be owed, this may also trigger state and federal penalties. If this is not enough, some of your investments in your 401k are sold to cover the amount borrowed. While you pay yourself interest on the loan, the money you have borrowed does not have an opportunity to get higher market returns. Have I missed anything as to why 401k loans should be among the last choices for borrowing? Except in the most dire emergencies, would there ever be a time when this was a good idea?

 

[Martha]

Only the interest you pay on the loan is taxed twice. You borrow the money and use it. That money was never taxed. So, when you put money back into the 401k you will have to pay tax on it when you take it out.

The big issue with borrowing money from a 401k is losing the growth of the funds that would occur while in the 401k.

Some years ago we borrowed half the money we had in my 401k to put a down payment on our first rental property. We paid the loan back fairly quickly. I would never advise anyone else to do that but it turned out that it worked great for us.

One other comment. It turns out that employees are more likely to contribute to a 401k if they know that they can borrow the money. I don't know if that is a good or a bad.

 

[rogerc1944]

Martha: Keep in mind that you don't repay a 401k loan with pretax/tax deferred money. You repay the loan with aftertax money.

 

[Animorph]

Unless the loan gets taxed as it comes out of the 401k, I agree with Martha. Regardless of where the loan came from it is payed off with after-tax money. The net effect on the 401k is just that you took some money out for some time (or allocated it to a fixed income investment). Doesn't your 401k get the interest payments as well as the principle payments?

Dan

 

[Martha]

Martha: Keep in mind that you don't repay a 401k loan with pretax/tax deferred money. You repay the loan with aftertax money.

It doesn't matter, because the loan money itself was never taxed. Someday it has to be taxed. Think of it as returing the never taxed money back to the 401k.

If you don't ever pay the loan back, it will be deemed a distribution and be taxed.

 

[jazz4cash]

On another thread, I pointed out that 401k loans were almost always a really bad

I agree 100%

A couple of people didn't seem to understand this double taxation problem. Except in the most dire emergencies, would there ever be a time when this was a good idea?

I fully understand why it "seems" like double taxation, but I agree with the others that believe it basically "evens out in the end", except for the "interest".

The big issue with borrowing money from a 401k is losing the growth of the funds that would occur while in the 401k.

I agree this IS the BIG issue that many do not understand. The "interest" that you "pay yourself" is meaningless, IMHO. They should not be allowed to be called "loans"........maybe "temporary liquidation" would be better

One other comment. It turns out that employees are more likely to contribute to a 401k if they know that they can borrow the money. I don't know if that is a good or a bad.

When my employer 1st rolled out the 401k in '83, the loan feature definitely contributed to my willingness to participate. Also at one point, I decided to withdraw some funds, but the HR clerk "suggested" a loan instead, so that worked out better than a withdrawal. Bottom line, I do agree with roger it's usually not a good idea, but for different reasons than double taxation

 

[albundyz]

ok, let's say you have a 401K investor who watched the market drop during 2001-2003. This person was spared big losses by having his/her 401K investment in a stable value fund earning 4% during that time.

Now it's 2007 and this person still does not trust the market so he/she still has all the funds in a stable value fund getting 4%.

ok, so this person needs $10,000, so he borrows from his 401K. He is now paying back his 401K at 8%.

(I have not done this, but....) isn't this person benefiting? because his 401K is now getting 8% interest rather than the 4% of the stable value? what am i missing?

 

[bosco]

ok, so this person needs $10,000, so he borrows from his 401K. He is now paying back his 401K at 8%.

(I have not done this, but....) isn't this person benefiting? because his 401K is now getting 8% interest rather than the 4% of the stable value? what am i missing?

if I buy beever cheeze at $10.00 and sell it back to myself for $11.00, have I made $1.00 profit

I must be missing something....

 

[albundyz]

bosco: explain it out to me

I take out a 10,000 loan at B of A. I pay them 8% interest. I take out a 10K loan from my 401K I pay 8% interest. I would pay an equal amount ok? Same amount of money comes out of my pocket.

If I leave my money alone in my 401K and it's invested in a stable value fund and it earns 4%. If I get repaid at 8% from the loan. Can't one argue that my 401K is better off after the loan is repaid?

I've never done this and I don't plan to. I'm just trying to understand why it's a bad idea to borrow on your 401K. I know I'm probably wrong, but what am I missing?

 

[bosco]

bosco: explain it out to me

I take out a 10,000 loan at B of A. I pay them 8% interest. I take out a 10K loan from my 401K I pay 8% interest. I would pay an equal amount ok? Same amount of money comes out of my pocket.

If I leave my money alone in my 401K and it's invested in a stable value fund and it earns 4%. If I get repaid at 8% from the loan. Can't one argue that my 401K is better off after the loan is repaid?

I've never done this and I don't plan to. I'm just trying to understand why it's a bad idea to borrow on your 401K. I know I'm probably wrong, but what am I missing?

ok, I misunderstood your question. So what you are saying is that given that you are going to borrow the money at 8% anyway, and given that if you didn't take the money out of your 401K, that you would absolutely leave it in the stable value at 4%, then what's wrong with the picture.

I figured I was missing something--that's why I said so in my previous post. Your question didn't make sense to me. Now I understand it.

Sorry....I'm being a litttle slow today.

On the face of it, what you are proposing seems to make sense. Of course, unless the person is very close to retirement, I'm not sure why they would leave it in 4% cash in the first place, but that's outside the parameters of how you framed the discussion.... For me what would be wrong with it would be the lost opportunity cost but if it's sitting at 4% that's already lost.

 

[rogerc1944]

Getting 8% on your money of course seems better that getting 4%. However, the 4% comes out of somebody else's pocket. The 8% comes out of your own. I suppose you could loan the money at 8% to somebody else and pay this into your own account. Seems complicated. Of course, I'm the guy who started this thread and I still believe that you get double taxed by borrowing from your 401k (paying back with after tax money for pretax money and then getting taxed again when you take it out when you retire). There are also big problems should you lose your job. You have to pay that money back or it's considered a distribution and you pay federal and state tax as well as penalties.

 

[bosco]

Getting 8% on your money of course seems better that getting 4%. However, the 4% comes out of somebody else's pocket. The 8% comes out of your own. I suppose you could loan the money at 8% to somebody else and pay this into your own account. Seems complicated. Of course, I'm the guy who started this thread and I still believe that you get double taxed by borrowing from your 401k (paying back with after tax money for pretax money and then getting taxed again when you take it out when you retire). There are also big problems should you lose your job. You have to pay that money back or it's considered a distribution and you pay federal and state tax as well as penalties.

but you can't have it both ways. You framed the terms of the debate. The terms were that you were going to borrow the money from someone at 8%. Given that fact, you were going to be making 8% interest payments with after tax money, regardless if you made them to your 401k or not. You'd be in trouble with that loan payment if you lost your job also.

 

[spideyrdpd]

Theoretically
You would get a slight advantage of spending money today that wont be taxed till later. For many people it will likely be taxed at a lower rate.
You can figure that people here and the american investors say to have 25% of your money in bonds. Bonds are a debt instrument your borrowing money is like creating a bond. You would then make sure the rest of your money is in stocks

The bigger issue is what people use the money they borrow for. Many people are underfunding . So it might be better to not borrow money and to up your payments to the 401k.

 

[jdmorton]

Even Though We Did Take Out a 401k Loan...

I agree that it should be the last resort. I would like to point out that it is also important to understand YOUR company's 401k loan rules. In our case, the rules are fairly strict. For example:

1. The maximum loan amount is either 50% of your vested account amount or $50,000 - whichever is less. No loan can exceed more than $50,000. This is the same for the two types of loans possible - general purpose or home purchase/home construction.

2. The maximum loan repayment term for a general purpose loan is from 1 to 4 years, in whole year increments - so you can't take out a loan for 30 months. The loan repayment term for home purchase or construction can range from 5 to 25 years. Again, in whole year increments only.

3. Repayment is automatic; it comes right out of every paycheck until the loan is repaid. It begins the very next paycheck after you take out the loan and does not stop until the loan is fully repaid. You have no say in this - if you want the loan, then you agree to the automatic paycheck repayment. Any, yes, it is an after-tax deduction.

4. You can have one general purpose loan and one home purchase/home construction loan at the same time.

5. The rules are also clear about what happens if you leave the company before the loan is repaid. Let's put it this way - you most likely would not voluntarily leave the company before repaying any 401k loan .

The 401k plan document given to each employee also outlines the advantages and disadvantages of taking out a loan from your 401k. Every disadvantage that has been discussed above is mentioned.

So, a natural question should be - if we knew all of the disadvantages, why did we take a 401k loan anyway? Well, two reasons:

1. After evaluating every other possible loan option, a 401k loan was the "best" one for us at that time.

2. Prior to taking out the loan, I took out every book I could find in the local library that were specifically written about 401k's - and there sure were a lot of them! In addtion, I took out a number of general personal financial books by a number of authors that have been discusse in this forum. I not only learned all of the disadvantages of taking out a 401k loan and what to look for if you do take one out, but I finally learned all about 401k's, asset allocation, diversification, stock to bond ratios, what to look for (and to avoid) in financial planners, and so forth. In other words, investigating a 401k loan forced me to finally investigate retirement planning and really start to understand all of this financial stuff (or, at least realize where I can go to get assistance for what I don't understand) already.

By the way, all of this occurred over 9 years ago now, and the loan has been paid off long ago. Would we do it again? Well, I don't think we would need to because we now have more resources and options for obtaining the necessary funds than we did back then.

Like Martha, our 401k loan worked out for us. But, it was because of careful planning and understanding what we were getting into - including all possible consequences. Unless you do that, then I would not advise anyone to take out such a loan.