Suze Orman and 401K loans

[Ready]

Suze is at it again.

Last night she told a viewer not to take out a 401K loan, because they will need to pay it back with after tax money, so they will be paying double taxes. I thought I must have heard her wrong, so I replayed the snippet. Nope, she actually said it. Her argument is that the loan money is being paid with after tax dollars, and somehow she equates that to double taxation.

What she seems to be ignoring is that the money in the fund was deposited pretax. So the money being used to pay it back is no different than paying back a traditional loan with after tax dollars. It has no impact on the taxes that were deferred on the original deposit.

What she also ignores is that the interest on a 401K loan is being paid back to yourself. So in effect, it's a loophole that allows someone to contribute more than $17,500 into a 401K per year, by contributing the entire $17,500 through payroll deposits, and then contributing the interest into the account on top of those funds. And the interest is money you are paying to yourself, not a lending institution.

So if you need to take out a loan and have the funds to do so in your 401K, I think it's a great option. You may run into trouble if you leave the company you are working for and may have to pay it back within 60 days, but otherwise it's a great deal.

As for Suze, I still enjoy watching her show and find it interesting to see the smattering of callers who present their various financial issues. But I was left seriously wondering, doesn't anyone double check what Suze tells these people just to prevent her from embarrassing herself and saying things that are completely ludicrous?

 

[LOL!]

The interest you pay back to yourself is double-taxed, but not the principal.

I think her viewers don't know the difference between interest and principal and a bunch of other financial things.

We used a 401(k) loan to invest.

 

[Texas Proud]

The interest you pay back to yourself is double-taxed, but not the principal.

I think her viewers don't know the difference between interest and principal and a bunch of other financial things.

We used a 401(k) loan to invest.

I still call BS on this logic....

ANY earnings in the 401(k) is going to be taxed.... ANY interest paid on any loan is going to be with money that has been taxed.... combining the two into one transaction does not change anything...


Let me explain the logic...

#1... you borrow money from the bank (not your 401)... you invest your 401 money into bonds.... to make it simple, the interest rates are the same....

You pay interest to the bank from ordinary income (it has been taxed)... eventually you take money out of your 401(k) and have to pay taxes on it... you have to pay taxes on the interest your bonds earned (the important part)...


#2... you borrow money from your 401(k)... your 401(k) 'investment' is the same as a bond, but it is not "YOU, Inc."....

You pay interest to your 401(k) from ordinary income (it has been taxed)... eventually you take money out of your 401(k) and have to pay taxes on it... you have to pay taxes on the interest your "bond" (the loan) earned....


What is the difference between #1 and #2 when it comes to taxes NOTHING.. the big difference is that the bank will probably charge you more interest than you can earn on investing in bonds... the bad part is that you might not be investing in bonds and would have earned more in the 401(k) if you had not taken out the loan....

 

[MasterBlaster]

The real problem with 401K loans is that any gains that would have occurred to the loaned out money are lost.

Had you taken out loans last year your real penalty would be the interest plus all the big lost gains from last year.

 

[Hermit]

I have told my children their retirement money is just that. It is not for a home loan or any other type of loan. It is not for their SO. It is there for their retirement and if their SO is there to enjoy it with them all the better.

If it takes someone saying something that is not technically correct, but helps them get the message that it is not wise to use retirement funds until retirement, I'm all for it.

I don't think FIRE participants are Suze Orman's audience.

 

[LOL!]

I still call BS on this logic....

Good on the BS call. I don't disagree, but let me add some details:

1. The loaned money was invested in a 529 plan, so gains on invested loan were tax-free because they were used to pay college expenses.

2. The loaned money was invested in the same asset class that it was invested in the 401(k), namely a bond fund. HOWEVER, the 401(k) bond fund had an expense ratio of about 2%, while the 529 plan bond fund had an expense ratio of about 0.3%, so just the difference in fees made the loan come out ahead.

3. The interest rate of the loan was higher than the return of the bond funds, so the 401(k) grew larger than it would have because the "loan" performed better than the bond fund AND fewer fees were removed (see 2 above).

Sometimes free money is hard to find, but when someone drops a few thousand dollars on the sidewalk, I pick it up.

More on #1 above: Some folks get a state income tax break for 529 plan contributions, but don't have enough money to fully contribute the max to 401(k) and contribute to 529 plans. Can you think of a way to have your cake and eat it, too?

 

[veremchuka]

The real problem with 401K loans is that any gains that would have occurred to the loaned out money are lost.

Had you taken out loans last year your real penalty would be the interest plus all the big lost gains from last year.

I was going to point this out. Imagine taking $100k out of your 401k late in Dec. 2012, say it was in equities, look at what the DJIA, S&P 500 and the NASDAQ returned last year! You pay yourself back at what 4%, 5%, 6%? What a deal! Don't say but if you invested it - it was invested!

I'm glad Texas Proud posted his comments cuz I've seen this in different threads here and elsewhere about how it does not matter and I say it does. You paid back before tax dollars with after tax dollars that when they are taken out in the future will be taxed. So that money was not taxed when it went into the 401k, then it was replaced with money that was taxed just to have it taxed again when you take the distribution. Tell me how that isn't crazy.

These loans are not a good idea and I think they should be abolished.

 

[LOL!]

On the subject of gains, bond funds lost money last year, so if one took a loan from their 401(k) bond fund and paid back at 4% or 5% interest rate, then their 401(k) would have gained over their bond fund in the 401(k).

Anyways, I agree that for many people, a 401(k) loan doesn't make sense, but when it does make sense, why not get one?

Try this:

One borrows $50K from 401(k) and puts it in their checking account. They take that money and use it to make payments on the 401(k) loan. Did that $50K get taxed because it came out of the 401(k)? No. Did it get taxed because it got paid back into the 401(k) as payment for the loan principal? No. Did it get double-taxed? No.

 

[Ticker]

so here's what I did. The interest on my house loan was not deductible as the standard deduction was larger than the sum of all of my deductions. I owed about $7k in interest for the remainder of the loan, I think it was about 5 years. I took a 401-k loan to pay off the house, and targeted my BOND allocation, and borrowed from that portion of money, leaving the Stock allocation intact. I paid off the mortgage (if you've never experienced it, you couldn't understand the feelings that go with THAT move), and repaid myself via paycheck deductions. The only risk I took was a loss of job, and then the risk was merely a tax issue.

Since I retained the interest that would have gone to the bank, and since I retained the stock allocation, I think I made a great move. Not for everyone, but when the bonds funds were paying less than 2%, I was earning 6, and netted a nice increase.

 

[Texas Proud]

Good on the BS call. I don't disagree, but let me add some details:

1. The loaned money was invested in a 529 plan, so gains on invested loan were tax-free because they were used to pay college expenses.

2. The loaned money was invested in the same asset class that it was invested in the 401(k), namely a bond fund. HOWEVER, the 401(k) bond fund had an expense ratio of about 2%, while the 529 plan bond fund had an expense ratio of about 0.3%, so just the difference in fees made the loan come out ahead.

3. The interest rate of the loan was higher than the return of the bond funds, so the 401(k) grew larger than it would have because the "loan" performed better than the bond fund AND fewer fees were removed (see 2 above).

Sometimes free money is hard to find, but when someone drops a few thousand dollars on the sidewalk, I pick it up.

More on #1 above: Some folks get a state income tax break for 529 plan contributions, but don't have enough money to fully contribute the max to 401(k) and contribute to 529 plans. Can you think of a way to have your cake and eat it, too?

You added a third component to the equation.... and if I follow you, you invested the loaned money in the 529 which had a higher interest rate than the 401(k)... good job!! However, it does not change the two examples that I gave... you just added when the loaned money went and it was a good place...

BTW, I would not have borrowed money from the bank to put into a 529 plan as the loan interest would likely have been higher than the bond fund interest, or a negative net yield...

 

[Texas Proud]

I was going to point this out. Imagine taking $100k out of your 401k late in Dec. 2012, say it was in equities, look at what the DJIA, S&P 500 and the NASDAQ returned last year! You pay yourself back at what 4%, 5%, 6%? What a deal! Don't say but if you invested it - it was invested!

I'm glad Texas Proud posted his comments cuz I've seen this in different threads here and elsewhere about how it does not matter and I say it does. You paid back before tax dollars with after tax dollars that when they are taken out in the future will be taxed. So that money was not taxed when it went into the 401k, then it was replaced with money that was taxed just to have it taxed again when you take the distribution. Tell me how that isn't crazy.

These loans are not a good idea and I think they should be abolished.

I agree with you in that a loan from stock investments are not the same.... but if it is bonds... then my above example is still correct...


Also, you cherry pick on your timing.... say they took out the loan at the beginning of 2008 and paid if off in early 2009.... then they looked like a genius.... I still would not take a loan out of a stock fund...

 

[Texas Proud]

I was going to point this out. Imagine taking $100k out of your 401k late in Dec. 2012, say it was in equities, look at what the DJIA, S&P 500 and the NASDAQ returned last year! You pay yourself back at what 4%, 5%, 6%? What a deal! Don't say but if you invested it - it was invested!

I'm glad Texas Proud posted his comments cuz I've seen this in different threads here and elsewhere about how it does not matter and I say it does. You paid back before tax dollars with after tax dollars that when they are taken out in the future will be taxed. So that money was not taxed when it went into the 401k, then it was replaced with money that was taxed just to have it taxed again when you take the distribution. Tell me how that isn't crazy.

These loans are not a good idea and I think they should be abolished.

I think you are reading my post incorrectly.... I am saying that if you take the loan from a bond fund.... it probably does not matter... and in fact may be better than the bond fund... if the loan has a higher interest rate than the bond fund, your 401(k) has more money after you pay off your loan than it would if you had kept it in the bond fund...


If you took the loan from equities, then all bets are off... you cannot tell if it was a good move or bad move until it is too late... as I said in a couple of posts ago... it done in 2008 it was a great move.... in 2012, not so much...

I might take money out if I had it in a bond fund.... I never would take it out of equities.... but, I have enough money elsewhere that I will never have to make this decision....

 

[skipgimp]

You are wrong and Suze is correct about the additional taxation

Let's do some simple math related to a 'typical' 401k loan....
1. You put in $10,000 pretax into a 401k when you are in the 25% federal tax bracket. You needed to earn $10,000 in PRE-TAX SALARY to make that contribution.
2. You take out a $5,000 loan from that 401k "paying yourself back" with a 6% interest. If your loan repayment terms are for 5 years at 6%, then the monthly payment is $96.66.
3. You have to earn $120.83 in PRE-TAX SALARY to make that $96.66 payment. The $96.66 monthly repayment (that includes the 6% you are "paying yourself back") will be the equivalent of $5,800 at the end of the loan term.
4. In order to get to the $5,800, you had to earn $7,250 in PRE-TAX SALARY.
4. You take that same $5,800 out for retirement income, it is taxed again. If you are in the 25% federal tax bracket, that $5,000 will be $4,640 after taxes.

Here's the take home:
When you go to withdraw the money for income in retirement, assuming you are still in the 25% federal tax bracket, $7,250 in PRE-TAX SALARY was necessary (60 X $120.83 in monthly loan repayments) to get $4,640 in after tax income in retirement. That is a 36% effective tax rate.

If you had not taken the 401k loan, then you would have needed $6,187 in PRE-TAX SALARY to get that same $4,640 in after tax income in retirement.

I would prefer to only have to earn the $6,187....
----drops microphone----

 

[kgtest]

The real problem with 401K loans is that any gains that would have occurred to the loaned out money are lost.

Had you taken out loans last year your real penalty would be the interest plus all the big lost gains from last year.

Another way to look at it is postponing opportunity.

Without the 401k money, there is a lost opportunity cost.

 

[veremchuka]

I think you are reading my post incorrectly.... I am saying that if you take the loan from a bond fund.... it probably does not matter... and in fact may be better than the bond fund... if the loan has a higher interest rate than the bond fund, your 401(k) has more money after you pay off your loan than it would if you had kept it in the bond fund...


If you took the loan from equities, then all bets are off... you cannot tell if it was a good move or bad move until it is too late... as I said in a couple of posts ago... it done in 2008 it was a great move.... in 2012, not so much...

I might take money out if I had it in a bond fund.... I never would take it out of equities.... but, I have enough money elsewhere that I will never have to make this decision....

I do see now that if you took it from a bond fund that was paying next to nothing you'd get more return from the interest you pay plus if rates rose there's no nav loss on the loan amount that was out of the bond fund. Equities are too risky in that the returns could be much higher or lower in the equity fund. Yep cherry pick the year!

I can't remember but if you pay back the loan with pre tax dollars then the money isn't taxed for the repayment and it then is taxed just once at distribution. If you pay the loan with after tax then I think it's a bad deal as you pay tax on those loan dollars twice - once as you pay it back and again when you take a distribution. If that is wrong then I'm missing something!

 

[Texas Proud]

Let's do some simple math related to a 'typical' 401k loan....
1. You put in $10,000 pretax into a 401k when you are in the 25% federal tax bracket. You needed to earn $10,000 in PRE-TAX SALARY to make that contribution.
2. You take out a $5,000 loan from that 401k "paying yourself back" with a 6% interest. If your loan repayment terms are for 5 years at 6%, then the monthly payment is $96.66.
3. You have to earn $120.83 in PRE-TAX SALARY to make that $96.66 payment. The $96.66 monthly repayment (that includes the 6% you are "paying yourself back") will be the equivalent of $5,800 at the end of the loan term.
4. In order to get to the $5,800, you had to earn $7,250 in PRE-TAX SALARY.
4. You take that same $5,800 out for retirement income, it is taxed again. If you are in the 25% federal tax bracket, that $5,000 will be $4,640 after taxes.

Here's the take home:
When you go to withdraw the money for income in retirement, assuming you are still in the 25% federal tax bracket, $7,250 in PRE-TAX SALARY was necessary (60 X $120.83 in monthly loan repayments) to get $4,640 in after tax income in retirement. That is a 36% effective tax rate.

If you had not taken the 401k loan, then you would have needed $6,187 in PRE-TAX SALARY to get that same $4,640 in after tax income in retirement.

I would prefer to only have to earn the $6,187....
----drops microphone----

New to the game here.... welcome...

You are wrong... dead wrong.... you are giving only one possibility.... if you took out a loan from a bank, you still have to earn the higher amount to pay it off.... so that is a NET zero between a bank loan and a 401(k) loan....


Now, the earnings in the 401(k) will be taxed either way... you either earn money from a bond fund OR the interest you pay yourself.... if the rate is the same... again, a NET zero between a loan and a bond fund...


SURE, you are being taxed 'twice' in your example, but you are being taxed the exact same amount (twice) if you did not take out the loan from the 401(k)... if the end result of money is the same either way, then there is no additional taxes you pay due to taking a loan from a 401(k)...

 

[Texas Proud]

I do see now that if you took it from a bond fund that was paying next to nothing you'd get more return from the interest you pay plus if rates rose there's no nav loss on the loan amount that was out of the bond fund. Equities are too risky in that the returns could be much higher or lower in the equity fund. Yep cherry pick the year!

I can't remember but if you pay back the loan with pre tax dollars then the money isn't taxed for the repayment and it then is taxed just once at distribution. If you pay the loan with after tax then I think it's a bad deal as you pay tax on those loan dollars twice - once as you pay it back and again when you take a distribution. If that is wrong then I'm missing something!

Yes, what you are missing is that if you take a loan, you probably need the money for something.... so your choice is a loan from the bank or your 401(k)... you are going to paying either your bank or your 401(k) back on this loan with money that is being taxed today... (now, we are assuming that you are paying it back with salary or some other earned income which is likely when someone is taking a loan from their 401(k)).....


It seems that everybody that is in the 'taxed twice' camp is forgetting that if the person does not take out that 401(k) loan, then they must take out a loan someplace else.... we are assuming that the person needs the money right now for whatever and will get that money someway....

 

[Ready]

It seems that everybody that is in the 'taxed twice' camp is forgetting that if the person does not take out that 401(k) loan, then they must take out a loan someplace else.... we are assuming that the person needs the money right now for whatever and will get that money someway....

Yes, exactly! That was the original point I was trying to make. If you can avoid taking out a loan completely, well then yes, there would be no loan to be paid back in after tax dollars.

But if you start with the assumption that a loan is going to happen either way, it's silly to argue that a 401K loan somehow has you incurring more taxes than a traditional bank or other third party loan.

Perhaps Suze's goal was to simply discourage someone from taking out a loan from their 401K in the first place because she thinks that's simply money that needs to stay in there until retirement. If so, fine. But confusing the point with arguments of double taxation simply throws a point out from left field that doesn't belong in the discussion.

 

[clifp]

I use to watch Suze on a rare occasions, but I've given up. She gives enough bad advice (to be fair along with plenty of good advice) that I wonder if on balance she does more harm than good.

 

[Sirka]

I've seen this in different threads here and elsewhere about how it does not matter and I say it does. You paid back before tax dollars with after tax dollars that when they are taken out in the future will be taxed. So that money was not taxed when it went into the 401k, then it was replaced with money that was taxed just to have it taxed again when you take the distribution. Tell me how that isn't crazy.

These loans are not a good idea and I think they should be abolished.

+1
you are right - don't touch 401k until it is time to roll it into IRA and Roth later. Pay taxes then at 15 % or no taxes at all. It is for retirement.