Employees Raiding 401Ks to Pay Bills

[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]

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'

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]

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]

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

 

[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]

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]

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]

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]

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]

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]

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

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.

 

[bamsphd]

Just to confuse things further

My credit union is currently offering a 15 year fixed NPNC mortgage with an interest rate of 6.50%.

My 401k is currently offering me a 10 year mortgage with an interest rate of 9.50% for the purchase (not refinance) of a house, or a 5 year consumer loan also at a 9.50% rate.

My 401k website says my "Personal Rate of Return from 01/01/2007 to 12/14/2007 is 3.9%." My 401k has spent the year 100% invested in a mix of Vanguard's S&P 500 and Extended Market index funds using the institutional share class with expense ratios of 0.05% and 0.07% respectively.

The other fine print is that I can borrow at most $50,000 from my 401k despite having a much larger vested balance. I can continue to contribute to my 401k and continue to receive the company match while I have an outstanding loan.

I'm not going to do it, but with those numbers my 401k balance would be better off if I had taken out a loan this year!

 

[Martha]

I am so tired of Orman's "double tax" claim about 401k loans. 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.

 

[free4now]

I am so tired of Orman's "double tax" claim about 401k loans. 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.

Right as always Martha. I was curious about this Orman quote, so I tracked it down. Here's the link to the article where she says:

Never ever borrow against your 401k plan because you will pay double taxation on the money you borrow. Because you don't pay taxes on the money you put into a 401k, when you pay back the loan (which you must do within five years, or 15 years if used to buy a home), you pay it back with money you have paid taxes on. Then, when you retire and take the money out again, you end up paying taxes on it a second time.

I made the same incorrect argument earlier in this thread where I wrote:

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.

So I hereby retract that.

But still there are two ways that you pay more tax with a 401k loan than on a deductible HELOC loan: the lost tax free compounding, and the loss of the interest payment deduction. It's just not the two ways that come to mind first!

 

[UncleHoney]

Now I'm really confused. (Not hard to do these days)

Here are the rules from my 401k plan with Vanguard. They even tell you you repay with after tax dollars and then get taxed again when you make withdrawals from the plan.



Although the Plan is designed for long-term savings, you may borrow from your account and pay yourself back with interest. Following are the loan provisions:

• Minimum loan amount: $1,000.
• Maximum loan amount: 50% of your vested account balance up to $50,000 (or less if you have had an outstanding Plan loan in the past 12 months).
• Maximum outstanding loans: two (with only one primary residence loan outstanding at any time).
• Repayment period: up to 5 years for a general purpose loan; up to 15 years for a primary residence loan.
• Loan application fee: $40 (one time only; deducted from your loan amount).
• Loan maintenance fee: $25 (annual; only applies to loans requested from Vanguard; deducted from the balance in your account).

Your Plan gives you the option to make an early lump-sum loan payoff.

Note: Your Plan does not allow partial payments. When you are ready to pay the loan in full, follow the steps listed under Take Action.
Take Action
Before taking a loan, consider the following.

• You reduce the amount of savings available to grow and compound for your retirement.
• You may have to work longer to make up lost ground.
• You have to pay the entire balance within 60 days if you end employment.
• You pay your loan back with after-tax dollars, and then you pay taxes on the money again when you withdraw it at retirement.
• You pay a one-time loan application fee of $40 and an annual maintenance fee of $25 for the life of your loan.

 

[UncleHoney]

I think I see the light now. You didn't pay tax on the original money and didn't have to pay tax on the loan money. So you got maybe $50k to use tax free. Now you have to earn another $50k and pay taxes on it and then pay the loan back then pay taxes again when you make withdrawals. So in the end you pay taxes on $100k. All comes out in the wash.

 

[free4now]

All comes out in the wash.

Right. You do pay tax twice on 401k loans, but you also pay twice with any other loan so it makes no difference. All loans are paid back with post tax dollars, not just 401k loans so that is not a concern. And you will pay tax on your 401k withdrawals whether you have previously used 401k loans or not so that also comes out in the wash.

 

[jazz4cash]

Wow- This really got twisted. I think we agree 401k loans are generally not a good source of funds and should only be used when no other options are available. Therefore if you're choosing between a 401k and a HELOC, for example....you don't get it. As I tried to stress, these are NOT LOANS....loans involve other people's money. I ve said before that using the term loan confuses most people and some other term should be used. 401k Loans are NOT MORTGAGES, so the interest will not be deductable.

I look at it as the only thing better than a withdrawal. Knowing that I can borrow in an emergency helps me justify a higher contribution rate...part of my emergency funds are in my 401k. When I have taken loans, I keep them very short if possible...like 6 months or just until I can get the funds some other way. I arrange the loan such that it is comming out of the fixed income portion of my AA which fixes the 'cost' of the loan and I do not give up any capital appreciation from my stock allocation.

Finally, I too am soo sick of Suze's nonsensical 'double taxation' argument, but it is probably effective at discouraging people from raiding thier 401ks.

 

[samclem]

Finally, I too am soo sick of Suze's nonsensical 'double taxation' argument, but it is probably effective at discouraging people from raiding thier 401ks.

Funny that in this same thread we have touched on two popular financial "entertainers" (Ramsey and Orman) who have given their listeners a good rule of thumb, but in each case their rationale for recommending it is faulty.

 

[Helena]

Funny that in this same thread we have touched on two popular financial "entertainers" (Ramsey and Orman) who have given their listeners a good rule of thumb, but in each case their rationale for recommending it is faulty.

Their rationale is not faulty.

 

[RunningBum]

Their rationale is not faulty.

Let's try it this way. You took a "loan" out of your 401K, and used that money without having to pay any tax. You didn't pay a tax when you put it in the account, and you didn't pay a tax when you disributed it in the form of this loan. So at this point you are actually -1 in paying taxes.

When you pay it back with after tax money, you are just getting it back to where it should be. You are back at 0 on taxes.

Then when you withdraw it in retirement, you actually pay your single tax on it.

I haven't gotten my arms around whether the interest is double taxed. Looking at the loan portion of it, whether it is interest to a bank or to your 401K, that money is gone. Inside the 401K account, that principal was going to make money, either on your loan from outside the account or from other investments in the account, so you'll pay taxes on that profit either way. So I don't think it does.

The way to calculate this is to use the same rate for your 401K loan, an alternative loan that is not tax-deductible (i.e., not a home equity loan), and your 401K investment return had you left it in the account. If the numbers work out the same for taking the 401K loan or leaving the 401K funds alone and taking an alternate loan, there is no extra tax. And I think they will work out the same if the rates are all the same.