Employees Raiding 401Ks to Pay Bills

[Bestwifeever]

For my plan you could take out up to $50,000 for a "general purpose loan" that has a 5-year payback period (the route we took for DD's wedding--certainly not the maximum, by the way). The interest you pay goes back in your own account, and you can keep making contributions during this period, too. You can also take out an undetermined amount to buy a house (it may be only good for your first house) that acts like a mortgage and must be paid back within a 30 year period. I don't know if that interest goes back in your own account but you can also keep making contributions during that period. Neither loans proceeds are taxable; neither loan has a penalty.

Neither one of these is cashing out or terminating--they are loans. A withdrawal (hardship, after retirement, whatever is allowed) is different. For my plan, when you take a withdrawal, you take money out of your account permanently. You may need to pay taxes on the amount you withdraw. You may also need to pay a penalty tax if the withdrawal is considered an early distribution from the plan.

Not advocating anyone to take out a loan like we did, but it did work for our circumstances....

[jazz4cash]

Quote:

Originally Posted by Puzzley Most 401(k) plans have a loan provision by which you can borrow from your account, and then begin making payments. You are, in effect, paying yourself, including interest. However, in my plan, for example, you cannot contribute to the plan duing your payback period. You should check with your plan administrator for more specific details. In general, while taking a loan is not a good idea because it is a detour in the road to retirement, it's better than cashing one out, by far...

The 'loan' provision in our plan (and all plans) I believe is actually not a loan at all. The assets are sold and the proceeds provided to the employee. It's only a 'loan' in the sense that it must be repaid. The non-loan feature is significant because the liquidated assets cannot appreciate, so the borrower's 'cost' may be unknown. If possible, structure the loan from the fixed interest assets. Sometimes 401k funds can be rolled over to an IRA and then withdrawn penalty-free for firsttime home purchase

[rocketdog]

Hmm, it sounds like there is a lot of variation in how the 401(k) plans are administered. I guess it pays to look into all the angles. The amount of money in his plan isn't too big, he told me it would be about $5000. But this is the ONLY retirement account he has. He's 32, about to have a baby in a couple of months. He sees that I am retiring early, since I'm 52 and will retire at the end of December (yay!). He'd love to do the same one day, but it sure isn't going to happen if he raids his 401(k)!

[bamsphd]

Quote:

Originally Posted by jazz4cash The 'loan' provision in our plan (and all plans) I believe is actually not a loan at all. The assets are sold and the proceeds provided to the employee. It's only a 'loan' in the sense that it must be repaid. The non-loan feature is significant because the liquidated assets cannot appreciate, so the borrower's 'cost' may be unknown. If possible, structure the loan from the fixed interest assets. Sometimes 401k funds can be rolled over to an IRA and then withdrawn penalty-free for firsttime home purchase

The borrower's 'cost' is similar to investing the 401k into a stable-value fund, with the additional advantage that your loan interest rate is very good. However, I would certainly not advocate investing much of your 401k in a stable-value fund for very long.

The problem with rolling it into an IRA and then withdrawing if "penalty-free" is that there is no way to put the money back into the IRA, assuming you were already at the legal limit on your 401k and IRA contributions.

[jazz4cash]

Quote:

Originally Posted by bamsphd The borrower's 'cost' is similar to investing the 401k into a stable-value fund, with the additional advantage that your loan interest rate is very good. However, I would certainly not advocate investing much of your 401k in a stable-value fund for very long.

The cost could be much higher depending on the source of the funds.
I believe a practical way to view these 'loans' is to consider the loss in growth of the assets liquidated to fund the 'loan'. So if the proceeds of the loan came from an asset that grew 10%/year, the cost of the loan would be 10% per year This 'cost' would be reduced a bit each year as the proceeds are replaced. Our plan lets us select individual investments to use for the loan....alternatively, you could re-allocate (out of the stable-value type) funds after taking the 'loan'

Quote:

The problem with rolling it into an IRA and then withdrawing if "penalty-free" is that there is no way to put the money back into the IRA, assuming you were already at the legal limit on your 401k and IRA contributions.

I agree.....the 'loan' is better than the rollover for home purchase, but OP mentioned 'cashing out' 401k which I don't believe has exceptions for the 10% penalty...maybe depends on the plan.

[citrine]

I know for myself.....I would not want to tap into my 401K because things happen....and if I were to get laid off....I wouldn't be able to pay it off.
I am currently in about 4K debt (1.98 interest rate) due to all the vet bills this year with my little cats and have cut out all luxuries and took on a babysitting job over the weekends. Tapping into my 401K is not even a thought.....especially when there are other ways to make some money.

[bamsphd]

Quote:

Originally Posted by bamsphd The borrower's 'cost' is similar to investing the 401k into a stable-value fund, with the additional advantage that your loan interest rate is very good. However, I would certainly not advocate investing much of your 401k in a stable-value fund for very long.

Quote:

Originally Posted by jazz4cash The cost could be much higher depending on the source of the funds. I believe a practical way to view these 'loans' is to consider the loss in growth of the assets liquidated to fund the 'loan'. So if the proceeds of the loan came from an asset that grew 10%/year, the cost of the loan would be 10% per year This 'cost' would be reduced a bit each year as the proceeds are replaced. Our plan lets us select individual investments to use for the loan....alternatively, you could re-allocate (out of the stable-value type) funds after taking the 'loan'

I think we are saying almost the same thing. I was trying to say the "cost" was similar to changing one's asset allocation from whatever (probably heavily equity based) allocation one currently had to a 100% stable value allocation.

[jazz4cash]

Quote:

Originally Posted by bamsphd I think we are saying almost the same thing. I was trying to say the "cost" was similar to changing one's asset allocation from whatever (probably heavily equity based) allocation one currently had to a 100% stable value allocation.

I see your point.....never thought of it that way, though. And of course, if equities drop after you have taken a loan against them, it could be beneficial.

[free4now]

I took a 401k loan for a home downpayment many years ago, because by providing a bigger downpayment I got a better loan deal. But I probably wouldn't recommend that knowing what I now know; I didn't quite understand all the tax disadvantages of 401k loans:

- You lose a lot of tax free compounding in the 401k. Not only while the money is out on loan. Even after you pay it back you lose tax free compounding every year until retirement because you can never "catch up" to raise your 401k balance up to what you would have had if you didn't take the loan. (Assuming you are maxing your 401k every year)

- You pay back the money with post-tax dollars, and then you'll have to pay tax on that money again when you take it out of the 401k upon retirement.

- You lose the interest deduction that you would have if you had used say a home equity loan instead of the 401k loan.

For most situations I think conventional loans are a better approach.

[Helena]

I watched the Suze Orman show last night.
She said do NOT borrow from your 401K.
She said you are borrowing tax free money
and paying it back with taxed money... so
when you pull the repaid taxed money out
at retirement it is taxed again... in other
words, the borrowed money you repay is
taxed twice !

[MooreBonds]

Quote:

Originally Posted by Helena I watched the Suze Orman show last night. She said do NOT borrow from your 401K. She said you are borrowing tax free money and paying it back with taxed money... so when you pull the repaid taxed money out at retirement it is taxed again... in other words, the borrowed money you repay is taxed twice !

This is one [of many ] argument I never understood from the talking idiots heads...

(PRE-REPLY DISCLAIMER: I understand the dangers of losing your job and paying back the 401(k) loan or face a penalty and taxes. This post merely looks at the financial comment quoted above concerning paying your 401(k) back which will later be taxed).

If you can take out a loan against your 401(k) at 7.5% without fees
vs
taking out a loan in a HELOC at 8.0%

why does it matter if you eventually withdraw the 401(k) and are taxed again? It doesn't matter if your 401(k) is invested in an international fund that grows 7.5%/year or if it's invested in Mr. Bob's Short Term Loan yielding 7.5% - it will grow by 7.5%/year. You still pay the same taxes on it at withdrawal.

And why pay a stranger a higher interest rate on your loan if you can get a cheaper loan from your 401(k) and pay yourself?

It's like Dave Ramsey, et. al.'s advice of never taking a loan out against your car because it's a "depreciating asset".

Can someone please explain to me the differences in these balance sheets?

Balance Sheet A
Home value $300,000
Car Book Value $10,000
Home Mortgage @ 7% <$5,000>
Net Worth $305,000

Balance Sheet B
Home Value $300,000
Car Book Value $10,000
Car Loan @ 7% <$5,000>
Net Worth $305,000

I understand that car loans aren't tax deductible, and that their rates are sometimes higher than mortgage rates....but those differences aside, I guess they're just trying to explain it to those that would finance their entire car purchase, and be forever in car debt since they never pay off their car loan before trading it in for their next car (and more car debt)? And don't want to try and explain the above differences because it would just confuse those that barely understand personal finance to begin with:confused:

[RunningBum]

I agree with MooreBonds. Unless the 401K plan has a provision that you can't contribute while you have a loan out--which I'd never heard of until a poster here mentioned it--there's not much difference.

You have a loan at X%. As far as the loan goes, it doesn't matter where you got it from. Chances are that a no-fee 401K loan with a lower interest rate will be better than anything else you can get these days. And no matter where you get the loan from, you are paying it back with post tax dollars.

Your 401K gets a return on investments. The drawback here is that the interest rate you are paying back into the 401K is probably less than the average return you can get from one of the 401K funds. This is a pretty good reason for not doing it, but you have to compare that to the difference in loan rates. And no matter whether your 401K builds by your investments or your loan balance, you will pay a tax on it when you withdraw.

The more I hear about what Suze Orman says, the more I realize I'm smart for not reading her advice in the first place. I guess technically it's true that you get taxed twice. But guess what? If you take out a different loan, you have to pay that back with after tax dollars. And if you don't use a 401K loan, and leave that money in the 401K, when you eventually withdraw that money, the extra you made on appreciation gets taxed. So you get taxed twice!! Do the math. The only difference will be due to the interest and appreciate rates.

The danger of losing your job and having to pay back the loan balance or pay the 10% penalty probably trumps everything else and makes this a bad idea.

[samclem]

Quote:

Originally Posted by MooreBonds It's like Dave Ramsey, et. al.'s advice of never taking a loan out against your car because it's a "depreciating asset".

I think they should say "spend as little as practical on depreciating assets, because they decrease your net worth." Regarding loans to buy a car: Since a loan makes it possible for people to spend more on this depreciating asset, especially people who have almost no savings, then it is probably a good thing to tell his audience to avoid doing it. Still, he'd do them a bigger favor by explaining why.

[Helena]

Quote:

Originally Posted by MooreBonds It's like Dave Ramsey, et. al.'s advice of never taking a loan out against your car because it's a "depreciating asset". Can someone please explain to me the differences in these balance sheets? Balance Sheet A Home value $300,000 Car Book Value $10,000 Home Mortgage @ 7% <$5,000> Net Worth $305,000 Balance Sheet B Home Value $300,000 Car Book Value $10,000 Car Loan @ 7% <$5,000> Net Worth $305,000

You are kidding, right ?

You're not advocating taking loans
against used vehicles, are you ?

The value of a car decreases considerably
with increase in age and mileage, etc...
while a house, traditionally, increases in
value. But everyone knows that, right ?

[samclem]

Quote:

Originally Posted by Helena You are kidding, right ? You're not advocating taking loans against used vehicles, are you ? The value of a car decreases considerably with increase in age and mileage, etc... while a house, traditionally, increases in value. But everyone knows that, right ?

His example speaks for itself. The net worth of the individual is the same regardless of which asset secures the loan. The car is going to depreciate (and drag down the owner's net worth) regardless of how it was financed . In fact, you could make the case (though I wouldn't) that it is better to have the loan secured by the car for two reasons:
1) Ramifications of failure to pay. I'd rather have my car repossessed than be evicted from my home.
2) If you have a $10K loan balance on a car worth $6K, who is really in the "driver's seat?" If you default and the car is repossessed, you are actually ahead $4K (once the debt is written off).

All this ignores the big hit to one's credit, etc from any kind of default, plus the dishonorable nature of failing to fulfill an obligation (an old-fashioned concept which is no longer discussed).

[free4now]

Because some people don't seem convinced that 401k loans are a bad idea, let me run some numbers. I'll compare two people, the first who took a 401k loan and the second who left their 401k alone and took a home equity loan.

For both people, they start out with a 10k balance in their 401k and want to borrow 10k for 10 years. The interest rate for 401k loans is relatively unimportant since it's paid back to yourself, so lets assume it's 7% for both the 401k and HELOC loan. We'll assume the 401k grows at 10% per year. The monthly payments for both cases are the same: 116.11 per month. For simplicity's sake I'll leave out ongoing contributions to the 401k.

1. 401k loan person:
401k balance on first day of loan: 0
401k balance on last day of loan: 23,784
Tax savings from interest deductions: 0

2. Home equity loan person:
401k balance on first day of loan: 10k
401k balance on last day of loan: 27,070
Tax savings from interest deductions, assuming 33% marginal tax rate: $1297

So having made the exact same monthly payments on the same loan amount, the home equity loan case has saved $1297 in taxes and has a 401k loan balance $3286 higher, and that higher 401k balance will continue to compound tax free until retirement.

[samclem]

Quote:

Originally Posted by free4now Because some people don't seem convinced that 401k loans are a bad idea, let me run some numbers. I'll compare two people, the first who took a 401k loan and the second who left their 401k alone and took a home equity loan. For both people, they start out with a 10k balance in their 401k and want to borrow 10k for 10 years. The interest rate for 401k loans is relatively unimportant since it's paid back to yourself, so lets assume it's 7% for both the 401k and HELOC loan. We'll assume the 401k grows at 10% per year. The monthly payments for both cases are the same: 116.11 per month. For simplicity's sake I'll leave out ongoing contributions to the 401k. 1. 401k loan person: 401k balance on first day of loan: 0 401k balance on last day of loan: 23,784 Tax savings from interest deductions: 0 2. Home equity loan person: 401k balance on first day of loan: 10k 401k balance on last day of loan: 27,070 Tax savings from interest deductions, assuming 33% marginal tax rate: $1297 So having made the exact same monthly payments on the same loan amount, the home equity loan case has saved $1297 in taxes and has a 401k loan balance $3286 higher, and that higher 401k balance will continue to compound tax free until retirement.

Thanks for the useful example, and it probably applies to 75% of people. Of course, the 10% annual growth on savings might be a little generous looking ahead. And, of course, someone taking the standard deduction and not itemizing (there are still some of us out here!) gets no benefit from the HELOC. So, every situation is different: For an individual who doesn't itmeize and who would invest in Money Market funds (or who had poor performance in equities), the 401K loan might prove to be as good/better than a HELOC. Maybe.

[free4now]

Quote:

Originally Posted by samclem Thanks for the useful example, and it probably applies to 75% of people. Of course, the 10% annual growth on savings might be a little generous looking ahead. And, of course, someone taking the standard deduction and not itemizing (there are still some of us out here!) gets no benefit from the HELOC. So, every situation is different: For an individual who doesn't itmeize and who would invest in Money Market funds (or who had poor performance in equities), the 401K loan might prove to be as good/better than a HELOC. Maybe.

Actually the 401k is better even if there is no tax deduction on the HELOC loan... in that case you don't get the $1297 tax deduction from the example but you do still have the $3286 higher 401k balance.

The 401k is better even if it's not earning 10%... as long as it earns more than the 7% HELOC loan rate it will still end up with a higher balance in the HELOC loan case. The only time the 401k loan could come out ahead would be if you had your 401k in something so safe and low yielding that it was earning less than HELOC rates on average, but that would be unusual and a poor way to invest tax deferred accounts.

[MooreBonds]

Quote:

Originally Posted by free4now The 401k is better even if it's not earning 10%... as long as it earns more than the 7% HELOC loan rate it will still end up with a higher balance in the HELOC loan case. The only time the 401k loan could come out ahead would be if you had your 401k in something so safe and low yielding that it was earning less than HELOC rates on average, but that would be unusual and a poor way to invest tax deferred accounts.

Well, yes...I guess I assumed that the above was obvious enough to go without saying (that if your 401(k) earned a higher return than your HELOC, it makes sense to leave your 401(k) alone and take out a HELOC). That's why I said

Quote:

It doesn't matter if your 401(k) is invested in an international fund that grows 7.5%/year or if it's invested in Mr. Bob's Short Term Loan yielding 7.5% - it will grow by 7.5%/year.

It all depends on what you want to assume your 401(k) grows at, and I was merely addressing the broad theory that it is inherently bad to take out a 401(k) loan because "you're putting money into your 401(k) with after-tax money".

And of course one would have to look at the after-tax net interest paid on the loan.....part of why I put a little disclaimer that my post was only focusing on the theory that the 401(k) payments were being 'taxed twice' while the standard HELOC/traditional loan is 'not taxed twice' - no other job-loss potential penalties/tax/etc. issues.

Because you could come up with multiple angles for virtually any situation one could come up with in the financial world -it all depends on how detailed you want to be.

[RunningBum]

If you can guarantee a better investment return rate than loan interest rate, you ought to mortgage your home to the hilt, buy stock on margin, etc.

But you're right, chances are it will do better. If you have home equity to dip into (without a lot of fees), that's probably the way to go. But if you're looking at a higher interest rate car loan, it's not so clear. You'd likely end up a bit worse off in your 401K, but more in your pocket, and you'd have to compare the difference and decide which is better.