Payoff 401K loan early?

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills.
Post Reply
Topic Author
viking112347
Posts: 26
Joined: Sun Apr 22, 2012 6:41 pm

Payoff 401K loan early?

Post by viking112347 »

I owe $12,000 on a 401K loan I made several years ago while purchasing my first home. I am re-paying the loan to my account with 5.75% interest. The repayment amount is $250 per month and the loan will be retired in 2017 if I continue to make scheduled payments.

Would it be recommended to payoff this loan now to get the money back into tax advantaged space and also free up $250 monthly or to just continue re-paying the loan (dollar cost averaging for the next 5 years)?
User avatar
Pennstateclj1
Posts: 501
Joined: Sun Apr 03, 2011 2:53 pm
Location: State College, PA

Re: Payoff 401K loan early?

Post by Pennstateclj1 »

If I could get a guaranteed 5.75% return, I'd take it.

So yes, I'd be aggressively paying that off assuming there are no other loans with a higher interest rate.
lawman3966
Posts: 1352
Joined: Sun Aug 10, 2008 12:09 pm
Location: Tacoma WA

Re: Payoff 401K loan early?

Post by lawman3966 »

More information is needed to provide a conclusive reply. However, I can suggest what additional information would aid in making the decision.

The benefit to paying early is avoiding taxes on your investment returns, and avoiding any annual fees charged to you for having an outstanding loan (if any).
The benefits to paying the loan back slowly (i.e. on the 2017 schedule) are (1) avoiding 401K fees on the loan amount outstanding; and (2) being able to place more money in tax-advantaged space through the payment of interest (I believe the interest is paid into your 401K account, but please correct me if this is wrong).

If you have high 401K fees, the answer is really a no brainer. In fact, some people have used 401K loans as a mechanism for liberating money from the 401K fee system, while still preserving the contribution tax break, and the amount of tax advantaged space they'll have once the loan is repaid.

Unless your 401K plan has egregiously high loan maintenance fees (your plan's terminology may use different language for this), I'd personally pay the loan back on the slow schedule.
Topic Author
viking112347
Posts: 26
Joined: Sun Apr 22, 2012 6:41 pm

Re: Payoff 401K loan early?

Post by viking112347 »

Even though I am paying the interest rate to myself?
User avatar
Pennstateclj1
Posts: 501
Joined: Sun Apr 03, 2011 2:53 pm
Location: State College, PA

Re: Payoff 401K loan early?

Post by Pennstateclj1 »

viking112347 wrote:Even though I am paying the interest rate to myself?
Check these out-

http://money.cnn.com/2006/08/25/pf/expe ... /index.htm

http://money.cnn.com/2005/03/29/pf/expe ... /index.htm
livesoft
Posts: 85973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Payoff 401K loan early?

Post by livesoft »

We have a 401(k) loan that we are paying as slow as possible. We may even take out another loan before this one is paid off.

There is no reason to pay it off early. By taking out the loan you have preserved the max 401(k) space possible, plus you get a guaranteed 5.75% increase in that space for the outstanding loan amount (OK, you know what I really mean). You cost is the extra income taxes on the loan interest that you pay which is probably not much at all.
Wiki This signature message sponsored by sscritic: Learn to fish.
Topic Author
viking112347
Posts: 26
Joined: Sun Apr 22, 2012 6:41 pm

Re: Payoff 401K loan early?

Post by viking112347 »

Great...thanks for the replies!...I will continue re-paying on the slow schedule.
User avatar
Pennstateclj1
Posts: 501
Joined: Sun Apr 03, 2011 2:53 pm
Location: State College, PA

Re: Payoff 401K loan early?

Post by Pennstateclj1 »

livesoft wrote:There is no reason to pay it off early. By taking out the loan you have preserved the max 401(k) space possible, plus you get a guaranteed 5.75% increase in that space for the outstanding loan amount (OK, you know what I really mean).
So if I understand correctly, ideally you'd want a 401k loan of even higher interest, to avoid high 401k plan fees and get to pay yourself the interest to get more money into the account than the 17k limit? Or did I misunderstand?

Say you're maxing and you contribute $17k. You take out a 401k loan and the rate is 10%. Now you pay back the loan, plus continue to max out your contributions and you're getting 10% more money in there(principal and interest) than your regular contributions because you're paying the interest into the account too. Close or way off?
DFWinvestor
Posts: 202
Joined: Mon Mar 19, 2012 2:05 pm

Re: Payoff 401K loan early?

Post by DFWinvestor »

I am surprised to see a thread on this topic because I've always heard you should never take out a 401K loan if it can be avoided, the reason being that if the market goes up you will ultimately be buying shares back that cost more than you originally paid for them, so although you are technically "paying yourself interest" you ultimately are likely to have a smaller portfolio in the long haul.

I suppose if you were fortunate enough to time the market, you could come out doing very well though.
Muchtolearn
Posts: 1563
Joined: Sun Dec 25, 2011 9:41 am

Re: Payoff 401K loan early?

Post by Muchtolearn »

Just pay it off because its good to pay it off :happy I have heard people say they are paying themselves interest. They aren't. You are paying yourself with your own money. Otherwise we would have 401K loans at 1000% and just pay ourselves.
User avatar
Epsilon Delta
Posts: 8090
Joined: Thu Apr 28, 2011 7:00 pm

Re: Payoff 401K loan early?

Post by Epsilon Delta »

lawman3966 wrote: Unless your 401K plan has egregiously high loan maintenance fees (your plan's terminology may use different language for this) ...
They usually call them "nominal maintenance fees". :P

Sorry, couldn't resist.
livesoft
Posts: 85973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Payoff 401K loan early?

Post by livesoft »

When we took out a 401(k) loan, we took it out of a high-expense-ratio bond fund and invested it in a low-expense-ratio bond fund in a 529 plan so that the gains were tax-free and the fees were almost 2% less. The money was never "out of the market". The reality is that we did not even change our asset allocation, but simply moved money from a 401(k) to a 529 plan. If we lose our jobs, we have enough money to pay off the loan promptly.

As it turned out, the 401(k) will have a higher value than without the loan because the interest rate for the 401(k) loan exceeds the return of the bond fund so far. Furthermore, the market went down, so being out of the market would have been a plus anyways. :) It is almost tempting to take out a loan from our other 401(k) and invest in a taxable account at the market highs. That way, we can potentially tax-loss harvest which we would not be able to do in a 401(k) while preserving the value of the 401(k) for the future. :twisted:

If one does take out a 401(k) loan and is worried about "market return" or "being out of the market", I would suggest that they adjust their asset allocation to treat the loan as a bond fund, thus they would not be out of equities.

As for trying to have the highest possible loan interest rate in order to make your 401(k) larger, I don't think that is what you want to do. Remember that you will pay ordinary income taxes on that money in the future when you withdraw (unless you are livesoft who doesn't pay income taxes on 401(k) withdrawals). One should compare the putting lots of money in the 401(k) versus putting the money tax-efficiently in a taxable account.

I guess my major point is that one should look beyond the conventional wisdom of no-401(k)-loans and see if one really makes sense for themselves. They have made a few-thousand-dollars sense for us.
Wiki This signature message sponsored by sscritic: Learn to fish.
rr2
Posts: 1071
Joined: Wed Nov 19, 2008 9:04 pm

Re: Payoff 401K loan early?

Post by rr2 »

FYI, for those who want to take a 403b loan from TIAA CREF:

403b loans from TIAA CREF work differently from 401k loans. In my case you actually did not take the money from the 403b. All that was done was that the 403b accumulation was used as a collateral. The loan repayments and interest were being paid to TIAA CREF. You were not paying yourself the interest.
SpecialK22
Posts: 844
Joined: Tue Sep 01, 2009 3:16 pm

Re: Payoff 401K loan early?

Post by SpecialK22 »

livesoft wrote: As for trying to have the highest possible loan interest rate in order to make your 401(k) larger, I don't think that is what you want to do. Remember that you will pay ordinary income taxes on that money in the future when you withdraw (unless you are livesoft who doesn't pay income taxes on 401(k) withdrawals). One should compare the putting lots of money in the 401(k) versus putting the money tax-efficiently in a taxable account.
I wonder if the situation changes for those in plans which allow in-service distributions? Assuming that loan repayments are eligible for in-service distribution, would it not make sense to take out a loan with the intent of rolling the interest to a Roth IRA? This way someone might be able to effectively increase Roth space as well. Assuming this can be one, one issue that immediately comes to mind is that given the low interest rate environment a sizeable loan would probably need to be take out to make it "worth it." This could potentially present a problem for future cash flows.
livesoft
Posts: 85973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Payoff 401K loan early?

Post by livesoft »

I think under current law the biggest loan is $50K or half-of-401(k)-balance, whichever is less. Also the term of the loans is limited to 4 or 5 years. This is not a perpetual motion machine, but in the right circumstances very useful.
Wiki This signature message sponsored by sscritic: Learn to fish.
Sam I Am
Posts: 2062
Joined: Tue Feb 20, 2007 6:58 pm

Re: Payoff 401K loan early?

Post by Sam I Am »

Message deleted.
Last edited by Sam I Am on Tue Oct 08, 2013 2:18 pm, edited 1 time in total.
bberris
Posts: 2413
Joined: Sun Feb 20, 2011 8:44 am

Re: Payoff 401K loan early?

Post by bberris »

Its not really a loan. Its a withdrawal followed by increased deposits.
To prove this, look at your balances after the loan is paid to you. They have reduced your assets in all of your funds proportionally. You are not leveraged.

Compare that to taking out cash from your margin account. That is really a loan! Your assets have not changed, just your liability, and you have become leveraged.

Now that you know what you are doing in the real world, you can make an informed decision. Do you want to take money out of your retirement savings to be able to take a vacation? go to school? buy a car?. Would you be willing to defer your savings plan in order to do those things?
wander
Posts: 4419
Joined: Sat Oct 04, 2008 9:10 am

Re: Payoff 401K loan early?

Post by wander »

viking112347 wrote:Would it be recommended to payoff this loan now to get the money back into tax advantaged space and also free up $250 monthly or to just continue re-paying the loan (dollar cost averaging for the next 5 years)?
No rush! You are paying interest to yourself.
User avatar
market timer
Posts: 6535
Joined: Tue Aug 21, 2007 1:42 am

Re: Payoff 401K loan early?

Post by market timer »

It really depends on what you'd do with the money otherwise. If you have $12K sitting in a checking account earning at most 1%, why not pay off the loan?
petenice00
Posts: 1
Joined: Thu Jan 21, 2016 5:06 pm

Re: Payoff 401K loan early?

Post by petenice00 »

Can you explain what you did step by step? After you took a loan from your 401k plan (I.e. payoff debt or put downpayment on house), where did you direct your loan repayment funds? Doesn't your 401k plan expect the repayment to go back in there? How were you able to put the repayment in a 529 plan...I guess that's really what I'm asking. Thanks in advance.

livesoft wrote:When we took out a 401(k) loan, we took it out of a high-expense-ratio bond fund and invested it in a low-expense-ratio bond fund in a 529 plan so that the gains were tax-free and the fees were almost 2% less. The money was never "out of the market". The reality is that we did not even change our asset allocation, but simply moved money from a 401(k) to a 529 plan. If we lose our jobs, we have enough money to pay off the loan promptly.

As it turned out, the 401(k) will have a higher value than without the loan because the interest rate for the 401(k) loan exceeds the return of the bond fund so far. Furthermore, the market went down, so being out of the market would have been a plus anyways. :) It is almost tempting to take out a loan from our other 401(k) and invest in a taxable account at the market highs. That way, we can potentially tax-loss harvest which we would not be able to do in a 401(k) while preserving the value of the 401(k) for the future. :twisted:

If one does take out a 401(k) loan and is worried about "market return" or "being out of the market", I would suggest that they adjust their asset allocation to treat the loan as a bond fund, thus they would not be out of equities.

As for trying to have the highest possible loan interest rate in order to make your 401(k) larger, I don't think that is what you want to do. Remember that you will pay ordinary income taxes on that money in the future when you withdraw (unless you are livesoft who doesn't pay income taxes on 401(k) withdrawals). One should compare the putting lots of money in the 401(k) versus putting the money tax-efficiently in a taxable account.

I guess my major point is that one should look beyond the conventional wisdom of no-401(k)-loans and see if one really makes sense for themselves. They have made a few-thousand-dollars sense for us.
livesoft
Posts: 85973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Payoff 401K loan early?

Post by livesoft »

petenice00 wrote:Can you explain what you did step by step? After you took a loan from your 401k plan (I.e. payoff debt or put downpayment on house), where did you direct your loan repayment funds? Doesn't your 401k plan expect the repayment to go back in there? How were you able to put the repayment in a 529 plan...I guess that's really what I'm asking. Thanks in advance.
1. Borrow maximum from 401(k) plan which was $50,000. Since the 401(k) was invested in PIMCO bond fund with 1.9% or so expense ratio, this means savings of about $950 in expenses for the next year although the $50,000 principal is slowly going down because of payments.

2. Get check for $50,000 and deposit into checking account.

3. Mom puts $12,500 into oldest child's 529 plan. Dad does the same. That's $25,000. The money goes into a bond fund with expense ratio of about 0.2%.

4. Mom puts $12,500 into youngest child's 529 plan. Dad does the same. That's $25,000. The money goes into a bond fund with expense ratio of about 0.2%.

5. So that's $50,000 from a 401(k) plan into 529 plans with a reduction in expense ratios.

6. The $50,000 loan from the 401(k) must be paid back through payroll deduction, so select the longest payback period. Each payment is deducted from the paycheck and includes principal and interest. The interest rate was about 4.5%, so that is a better return than the bond fund in the 401(k) at that time. In other words, it looks to the 401(k) as if the $50,000 is invested in an stable value fund with guaranteed interest rate of 4.5%.

7. A couple years into the 401(k) loan repayment, the employer was sold, the 401(k) was closed, and the loan came due. The remaining loan principal was paid off from money raised by selling assets in a taxable investment account. The total 401(k) after loan payback was rolled over to an IRA where passively-managed low-expense-ratio index funds were purchased.

The combination of lower expense ratios for a couple of years, the tax-free gains in the 529 plans, the interest paid into the 401(k) all made this a win-win. Do you see how this process was better than simply selling assets in a taxable investment account and using the money to contribute directly to 529 plans?
Wiki This signature message sponsored by sscritic: Learn to fish.
User avatar
unclescrooge
Posts: 6264
Joined: Thu Jun 07, 2012 7:00 pm

Re: Payoff 401K loan early?

Post by unclescrooge »

Pennstateclj1 wrote:If I could get a guaranteed 5.75% return, I'd take it.

So yes, I'd be aggressively paying that off assuming there are no other loans with a higher interest rate.
You have it backwards.

The 5.75% is the interest the borrower pays to HIMSELF.

So the ideal course of action is to consider the loan a bond that yields 5.75%, and use that as part of the bond allocation.
User avatar
dm200
Posts: 23214
Joined: Mon Feb 26, 2007 1:21 pm
Location: Washington DC area

Re: Payoff 401K loan early?

Post by dm200 »

The way 401k "loans" work is almost nothing like an actual "loan". When you take out a 401k "loan", the funds come from liquidation of the investments in the 401k. You no longer have as much invested. When you pay it back (along with the 'interest') those funds buy investments in the 401k.

Because of the way that such "loans" work, it seems to me that you should pay back as soon as possible to get more tax advantaged money working for you.

So many people, who ought to know better, think these are actually borrowed money and that it does not affect your investments.
User avatar
Crimsontide
Posts: 729
Joined: Fri Oct 25, 2013 5:32 pm
Location: DFW Metromess

Re: Payoff 401K loan early?

Post by Crimsontide »

livesoft wrote:
petenice00 wrote:Can you explain what you did step by step? After you took a loan from your 401k plan (I.e. payoff debt or put downpayment on house), where did you direct your loan repayment funds? Doesn't your 401k plan expect the repayment to go back in there? How were you able to put the repayment in a 529 plan...I guess that's really what I'm asking. Thanks in advance.
1. Borrow maximum from 401(k) plan which was $50,000. Since the 401(k) was invested in PIMCO bond fund with 1.9% or so expense ratio, this means savings of about $950 in expenses for the next year although the $50,000 principal is slowly going down because of payments.

2. Get check for $50,000 and deposit into checking account.

3. Mom puts $12,500 into oldest child's 529 plan. Dad does the same. That's $25,000. The money goes into a bond fund with expense ratio of about 0.2%.

4. Mom puts $12,500 into youngest child's 529 plan. Dad does the same. That's $25,000. The money goes into a bond fund with expense ratio of about 0.2%.

5. So that's $50,000 from a 401(k) plan into 529 plans with a reduction in expense ratios.

6. The $50,000 loan from the 401(k) must be paid back through payroll deduction, so select the longest payback period. Each payment is deducted from the paycheck and includes principal and interest. The interest rate was about 4.5%, so that is a better return than the bond fund in the 401(k) at that time. In other words, it looks to the 401(k) as if the $50,000 is invested in an stable value fund with guaranteed interest rate of 4.5%.

7. A couple years into the 401(k) loan repayment, the employer was sold, the 401(k) was closed, and the loan came due. The remaining loan principal was paid off from money raised by selling assets in a taxable investment account. The total 401(k) after loan payback was rolled over to an IRA where passively-managed low-expense-ratio index funds were purchased.

The combination of lower expense ratios for a couple of years, the tax-free gains in the 529 plans, the interest paid into the 401(k) all made this a win-win. Do you see how this process was better than simply selling assets in a taxable investment account and using the money to contribute directly to 529 plans?
Sounds like the financial version of a Rube Goldberg device :happy
livesoft
Posts: 85973
Joined: Thu Mar 01, 2007 7:00 pm

Re: Payoff 401K loan early?

Post by livesoft »

Crimsontide wrote:Sounds like the financial version of a Rube Goldberg device :happy
True. But it is more like doing a rollover from a high-fee 401(k) plan to a low-fee IRA. Such a thing is often recommended on the forum. :sharebeer
Wiki This signature message sponsored by sscritic: Learn to fish.
mikelin08
Posts: 1
Joined: Fri Jan 26, 2018 10:20 am

Re: Payoff 401K loan early?

Post by mikelin08 »

How has no one pointed out the obvious? Taking loans out of 401(k)'s are extremely detrimental because of double taxation. Loans are taxed at ordinary income rates when you take it out, and when you pay the money back, you are paying it back with after-tax money. No one should encourage 401(k) loans unless they are absolutely necessary or if you have already done so.

If you have already done so, most plans specify that you can't contribute to your plan while the loan is outstanding, outside of paying back what you already took out. This means if you have a company match, you forgo any potential match amount that you would otherwise receive, like leaving free money on the table. You are giving up the tax-deferred growth on the full principal of the loan for the duration the money is out, you're giving up match, you're giving up additional contributions above that amount. Paying it off slowly will only slow you down, I can't see why people would encourage this.
ERISA Stone
Posts: 1626
Joined: Tue Jun 24, 2014 8:54 am

Re: Payoff 401K loan early?

Post by ERISA Stone »

mikelin08 wrote: Fri Jan 26, 2018 10:27 am How has no one pointed out the obvious? Taking loans out of 401(k)'s are extremely detrimental because of double taxation.
Because it's not really true. https://thefinancebuff.com/401k-loan-do ... -myth.html
mikelin08 wrote: Fri Jan 26, 2018 10:27 am
most plans specify that you can't contribute to your plan while the loan is outstanding
I don't agree with this either. I had not even seen this in practice until I saw it mentioned on this board. Most 401k plans do NOT suspend your contributions when you take out a loan. Maybe you are thinking of a hardship distribution, which requires a suspension of deferrals.
H-Town
Posts: 5876
Joined: Sun Feb 26, 2017 1:08 pm

Re: Payoff 401K loan early?

Post by H-Town »

ERISA Stone wrote: Fri Jan 26, 2018 10:49 am
mikelin08 wrote: Fri Jan 26, 2018 10:27 am How has no one pointed out the obvious? Taking loans out of 401(k)'s are extremely detrimental because of double taxation.
Because it's not really true. https://thefinancebuff.com/401k-loan-do ... -myth.html
mikelin08 wrote: Fri Jan 26, 2018 10:27 am
most plans specify that you can't contribute to your plan while the loan is outstanding
I don't agree with this either. I had not even seen this in practice until I saw it mentioned on this board. Most 401k plans do NOT suspend your contributions when you take out a loan. Maybe you are thinking of a hardship distribution, which requires a suspension of deferrals.
The interest portion gets double tax. The principal amount is not since it's similar to a car loan that you would get from a bank. Nevertheless, 401k loan a bad deal all around.

Assumptions
  • 401k plan loan amount of $10,000
    Payroll deduction is the only way to pay back this loan
    The participant is in the 25 percent federal tax bracket while working and when retired
    No state taxes
    To eliminate the impact of interest, assume the interest rate on this plan loan is 0 percent
    To simplify the example, assume only one payroll deduction payment for $10,000 to pay back the loan
Example

Loan origination: $10,000, no tax impact

Loan payback: One $10,000 payroll-deducted after-tax payment. $13,333 in gross earnings needed to realize the $10,000 after-tax payment resulting in $3,333 in taxes attributable to the payment.

Distribution of this $10,000 at retirement: $10,000 taxed at 25 percent resulting in $2,500 in taxes.

The total taxes paid on the $10,000 used for the 401k plan loan and then distributed at retirement are $5,833 (58 percent), more than double the amount of $2,500 (25 percent) that would be paid on a $10,000 distribution at retirement.
Time is the ultimate currency.
ERISA Stone
Posts: 1626
Joined: Tue Jun 24, 2014 8:54 am

Re: Payoff 401K loan early?

Post by ERISA Stone »

thangngo wrote: Fri Jan 26, 2018 11:30 am
ERISA Stone wrote: Fri Jan 26, 2018 10:49 am
mikelin08 wrote: Fri Jan 26, 2018 10:27 am How has no one pointed out the obvious? Taking loans out of 401(k)'s are extremely detrimental because of double taxation.
Because it's not really true. https://thefinancebuff.com/401k-loan-do ... -myth.html
mikelin08 wrote: Fri Jan 26, 2018 10:27 am
most plans specify that you can't contribute to your plan while the loan is outstanding
I don't agree with this either. I had not even seen this in practice until I saw it mentioned on this board. Most 401k plans do NOT suspend your contributions when you take out a loan. Maybe you are thinking of a hardship distribution, which requires a suspension of deferrals.
The interest portion gets double tax. The principal amount is not since it's similar to a car loan that you would get from a bank. Nevertheless, 401k loan a bad deal all around.

Assumptions
  • 401k plan loan amount of $10,000
    Payroll deduction is the only way to pay back this loan
    The participant is in the 25 percent federal tax bracket while working and when retired
    No state taxes
    To eliminate the impact of interest, assume the interest rate on this plan loan is 0 percent
    To simplify the example, assume only one payroll deduction payment for $10,000 to pay back the loan
Example

Loan origination: $10,000, no tax impact

Loan payback: One $10,000 payroll-deducted after-tax payment. $13,333 in gross earnings needed to realize the $10,000 after-tax payment resulting in $3,333 in taxes attributable to the payment.

Distribution of this $10,000 at retirement: $10,000 taxed at 25 percent resulting in $2,500 in taxes.

The total taxes paid on the $10,000 used for the 401k plan loan and then distributed at retirement are $5,833 (58 percent), more than double the amount of $2,500 (25 percent) that would be paid on a $10,000 distribution at retirement.
https://thefinancebuff.com/401k-loan-do ... -myth.html
H-Town
Posts: 5876
Joined: Sun Feb 26, 2017 1:08 pm

Re: Payoff 401K loan early?

Post by H-Town »

ERISA Stone wrote: Fri Jan 26, 2018 12:28 pm
thangngo wrote: Fri Jan 26, 2018 11:30 am
ERISA Stone wrote: Fri Jan 26, 2018 10:49 am
mikelin08 wrote: Fri Jan 26, 2018 10:27 am How has no one pointed out the obvious? Taking loans out of 401(k)'s are extremely detrimental because of double taxation.
Because it's not really true. https://thefinancebuff.com/401k-loan-do ... -myth.html
mikelin08 wrote: Fri Jan 26, 2018 10:27 am
most plans specify that you can't contribute to your plan while the loan is outstanding
I don't agree with this either. I had not even seen this in practice until I saw it mentioned on this board. Most 401k plans do NOT suspend your contributions when you take out a loan. Maybe you are thinking of a hardship distribution, which requires a suspension of deferrals.
The interest portion gets double tax. The principal amount is not since it's similar to a car loan that you would get from a bank. Nevertheless, 401k loan a bad deal all around.

Assumptions
  • 401k plan loan amount of $10,000
    Payroll deduction is the only way to pay back this loan
    The participant is in the 25 percent federal tax bracket while working and when retired
    No state taxes
    To eliminate the impact of interest, assume the interest rate on this plan loan is 0 percent
    To simplify the example, assume only one payroll deduction payment for $10,000 to pay back the loan
Example

Loan origination: $10,000, no tax impact

Loan payback: One $10,000 payroll-deducted after-tax payment. $13,333 in gross earnings needed to realize the $10,000 after-tax payment resulting in $3,333 in taxes attributable to the payment.

Distribution of this $10,000 at retirement: $10,000 taxed at 25 percent resulting in $2,500 in taxes.

The total taxes paid on the $10,000 used for the 401k plan loan and then distributed at retirement are $5,833 (58 percent), more than double the amount of $2,500 (25 percent) that would be paid on a $10,000 distribution at retirement.
https://thefinancebuff.com/401k-loan-do ... -myth.html
I know very well the article you linked. It's incorrectly ignoring the fact that the interest portion is double tax. Do you see how $3,333 is greater than $2,500?
Time is the ultimate currency.
ThriftyPhD
Posts: 870
Joined: Mon Jul 31, 2017 10:43 am

Re: Payoff 401K loan early?

Post by ThriftyPhD »

thangngo wrote: Fri Jan 26, 2018 12:58 pm
ERISA Stone wrote: Fri Jan 26, 2018 12:28 pm
thangngo wrote: Fri Jan 26, 2018 11:30 am
ERISA Stone wrote: Fri Jan 26, 2018 10:49 am
mikelin08 wrote: Fri Jan 26, 2018 10:27 am How has no one pointed out the obvious? Taking loans out of 401(k)'s are extremely detrimental because of double taxation.
Because it's not really true. https://thefinancebuff.com/401k-loan-do ... -myth.html
mikelin08 wrote: Fri Jan 26, 2018 10:27 am
most plans specify that you can't contribute to your plan while the loan is outstanding
I don't agree with this either. I had not even seen this in practice until I saw it mentioned on this board. Most 401k plans do NOT suspend your contributions when you take out a loan. Maybe you are thinking of a hardship distribution, which requires a suspension of deferrals.
The interest portion gets double tax. The principal amount is not since it's similar to a car loan that you would get from a bank. Nevertheless, 401k loan a bad deal all around.

Assumptions
  • 401k plan loan amount of $10,000
    Payroll deduction is the only way to pay back this loan
    The participant is in the 25 percent federal tax bracket while working and when retired
    No state taxes
    To eliminate the impact of interest, assume the interest rate on this plan loan is 0 percent
    To simplify the example, assume only one payroll deduction payment for $10,000 to pay back the loan
Example

Loan origination: $10,000, no tax impact

Loan payback: One $10,000 payroll-deducted after-tax payment. $13,333 in gross earnings needed to realize the $10,000 after-tax payment resulting in $3,333 in taxes attributable to the payment.

Distribution of this $10,000 at retirement: $10,000 taxed at 25 percent resulting in $2,500 in taxes.

The total taxes paid on the $10,000 used for the 401k plan loan and then distributed at retirement are $5,833 (58 percent), more than double the amount of $2,500 (25 percent) that would be paid on a $10,000 distribution at retirement.
https://thefinancebuff.com/401k-loan-do ... -myth.html
I know very well the article you linked. It's incorrectly ignoring the fact that the interest portion is double tax. Do you see how $3,333 is greater than $2,500?
It's described in the linked article.

Case 1: 401k loan. You borrow $10k. You pay back a month later with an after tax payment of $10,000 representing $13,333 in gross earnings.
Case 2: Bank loan. You borrow $10k. You pay back a month later with an after tax payment of $10,000 representing $13,333 in gross earnings.

Case 1 and 2: In retirement, withdraw $10k, pay $2500 in tax.

The results are the same. The amount you borrow is after tax, so you pay it back with after tax, regardless of where it comes from. Your 401k withdrawls are always taxed, regardless if you've taken a loan in the past or not.

You spent the $10k so it has to be after tax money. You're not being taxed twice, the $3,333 in your example is necessary to get $10k of after tax money, regardless of the source.
ThriftyPhD
Posts: 870
Joined: Mon Jul 31, 2017 10:43 am

Re: Payoff 401K loan early?

Post by ThriftyPhD »

I'll add another example.

Case 3: You save up $10,000 representing $13,333 in gross earnings. You spend the $10,000 rather than taking out a loan.

In retirement, withdraw $10k, pay $2500 in tax.

The entire loan part is irrelevant. However you get the money, you're spending it after tax, so your gross earning equivalent will be higher, but the same regardless of where you get it.
bowest
Posts: 193
Joined: Fri Feb 18, 2011 12:19 pm
Location: New York

Re: Payoff 401K loan early?

Post by bowest »

are you otherwise maxing out pretax contributions?
N10sive
Posts: 746
Joined: Thu May 05, 2016 6:22 pm

Re: Payoff 401K loan early?

Post by N10sive »

just an FYI this is a 5 year old thread
DrGoogle2017
Posts: 2528
Joined: Mon Aug 14, 2017 12:31 pm

Re: Payoff 401K loan early?

Post by DrGoogle2017 »

I never thought this was a good idea, plus the amount is very limiting, $50k, not a big amount to arbitrage one way or the other. But if you need money and has to do it then you have to do it.
ERISA Stone
Posts: 1626
Joined: Tue Jun 24, 2014 8:54 am

Re: Payoff 401K loan early?

Post by ERISA Stone »

DrGoogle2017 wrote: Fri Jan 26, 2018 1:39 pm I never thought this was a good idea, plus the amount is very limiting, $50k, not a big amount to arbitrage one way or the other. But if you need money and has to do it then you have to do it.
If you are only going to borrow money because the 401k loan is available, it's a bad idea. If you are going to borrow regardless, I think you should always consider your options. The 401k loan may or may not be the best choice.
Post Reply