Increase 401k Contribution Limits through Self Loans

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assumer
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Increase 401k Contribution Limits through Self Loans

Post by assumer » Thu Jul 10, 2014 12:06 pm

I have a solo 401k through etrade.

They allow you to take a loan against yourself for up to $50k. They make you pay yourself back 1% or something.

If I take that full loan, and pay back on a regular schedule (as well as make my normal 401k contributions), I can essentially increase the amount of tax sheltered space I have in my 401k by an additional $500 / year, correct?

mervinj7
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Re: Increase 401k Contribution Limits through Self Loans

Post by mervinj7 » Thu Jul 10, 2014 12:09 pm

Not sure if I'm misunderstanding your question, but if you took that money out of your 401k wouldn't you also lose the potential dividends and equity increase over that same time period?

assumer
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Re: Increase 401k Contribution Limits through Self Loans

Post by assumer » Thu Jul 10, 2014 12:12 pm

mervinj7 wrote:Not sure if I'm misunderstanding your question, but if you took that money out of your 401k wouldn't you also lose the potential dividends and equity increase over that same time period?
Yes, traditionally one would use it for a mortgage down payment or something. So that money would presumably be used for something you were going to purchase anyway. Essentially using your 401k as a savings vehicle.

But after you buy the house and start reaccumulating and paying yourself back, your total amount contributed to the 401k would be higher, yes?

But you could simply take the money out and store it in a brokerage account temporarily, paying some taxes along the way. I'm not sure how the taxes you'd pay along the way compare to the additional tax-sheltered space after paying yourself back.

bberris
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Re: Increase 401k Contribution Limits through Self Loans

Post by bberris » Thu Jul 10, 2014 12:24 pm

Incorrect. The interest and principle payback is not tax deductible.
It's also a little misleading when they call these distributions "loans". Investments will be sold in your account to fund the distribution. They will be repurchased when you make payments back to the 401k.

chocolatemuffin
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Re: Increase 401k Contribution Limits through Self Loans

Post by chocolatemuffin » Thu Jul 10, 2014 12:30 pm

Why loan the money to yourself? You can loan the money in your 401k to someone else (i.e. by buying bonds) and still earn the interest in your 401k.

livesoft
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Re: Increase 401k Contribution Limits through Self Loans

Post by livesoft » Thu Jul 10, 2014 12:42 pm

That's not quite correct. In theory, you would like to pay back the loan at a 3000% interest rate, right? That way, instead of paying back $50,000, you would end up paying back $1.5 million or more. That would increase your tax-deferred space, but what would it get you? Well, you would get to pay income taxes on the interest you paid twice. Once before you paid it to your 401(k) and once again when you withdrew it from your 401(k).

That written, I must say that we did take a loan out of a 401(k) and used the loan to invest. Oh the horror!

But the details are important:
1. We saved the 2% fund expense ratio fees that the money had to pay while sitting in the 401(k).
2. We moved from a bond fund in the 401(k) to a low-expense ratio bond fund in a 529 plan, so the investment was essentially the same, but lower fee.
3. The gains in the 529 plan were tax-fee.
4. The interest paid back to the 401(k) plan was a higher effective yield than the bond fund was earning.

For us the 401(k) loan was a very safe and guaranteed way to make a few thousand dollars more than not taking out the loan. One should not avoid accepting free money.
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assumer
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Re: Increase 401k Contribution Limits through Self Loans

Post by assumer » Thu Jul 10, 2014 12:45 pm

Hmm maybe I'm misunderstanding this.

Instead of simply keeping money for a down payment in a house in a brokerage account holding BND, for example, I figured it would be better to purchase and hold BND in my solo 401k with that money. This way I would get to deduct that money from my taxable income this year, when I may not want to purchase a house until a few years down the road.

Is this not a good reason to use 401k loans (assuming the alternative is I would have simply not contributed that down payment money to the 401k at all and kept it in a brokerage account with BND)?

livesoft
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Re: Increase 401k Contribution Limits through Self Loans

Post by livesoft » Thu Jul 10, 2014 12:49 pm

Yes, it is best to make the maximum contribution to your 401(k). Then find another way to make a down payment for a home. :)

One could borrow from the 401(k) to make a down payment, but unless one can pay off a 401(k) loan instantly, I would not recommend getting one.

Does your solo 401(k) even have a loan provision?
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assumer
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Re: Increase 401k Contribution Limits through Self Loans

Post by assumer » Thu Jul 10, 2014 12:55 pm

livesoft wrote:Yes, it is best to make the maximum contribution to your 401(k). Then find another way to make a down payment for a home. :)
That might be difficult, but I'll try!
livesoft wrote:One could borrow from the 401(k) to make a down payment, but unless one can pay off a 401(k) loan instantly, I would not recommend getting one.
Could you help me understand this with some dummy numbers?

Let's say I want to use $30k that I have in a checking account now for a down payment next year.

I choose to put an extra $30k in my solo 401k this year instead of putting it into a savings account.

I save about 25% * $30k = $7.5k in taxes this year.

I take that money out and use it next year for a down payment. I contribute my $17,000 next year to the 401k as I had always planned.

Over the following 10 years, I pay myself back that $30k into the 401k by recontributing (although as someone else says it's not deductible) $3,300 each year or so.

How is this not better than simply keeping it in my checking account, even if I can't pay it back right away? What am I missing here?
livesoft wrote:Does your solo 401(k) even have a loan provision?
Yes, that was one of the reasons I chose etrade instead of vanguard for it.

ERISA Stone
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Re: Increase 401k Contribution Limits through Self Loans

Post by ERISA Stone » Thu Jul 10, 2014 12:59 pm

assumer wrote:I have a solo 401k through etrade.

They allow you to take a loan against yourself for up to $50k. They make you pay yourself back 1% or something.

If I take that full loan, and pay back on a regular schedule (as well as make my normal 401k contributions), I can essentially increase the amount of tax sheltered space I have in my 401k by an additional $500 / year, correct?
Are you sure eTrade didn't say prime +1%? The interest rate must be "reasonable" and I don't think 1% would fly if you were to get audited.

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Ketawa
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Re: Increase 401k Contribution Limits through Self Loans

Post by Ketawa » Thu Jul 10, 2014 1:03 pm

livesoft wrote:That's not quite correct. In theory, you would like to pay back the loan at a 3000% interest rate, right? That way, instead of paying back $50,000, you would end up paying back $1.5 million or more. That would increase your tax-deferred space, but what would it get you? Well, you would get to pay income taxes on the interest you paid twice. Once before you paid it to your 401(k) and once again when you withdrew it from your 401(k).
What if it was a Roth 401k at a 3000% interest rate?
livesoft wrote:Yes, it is best to make the maximum contribution to your 401(k). Then find another way to make a down payment for a home. :)

One could borrow from the 401(k) to make a down payment, but unless one can pay off a 401(k) loan instantly, I would not recommend getting one.
I don't think there's anything wrong with taking a 401k loan. It's a way to go back in time and pretend you didn't max out contributions. Instead, it's like you saved in taxable, and I think Bogleheads in general would find it acceptable to save up for a down payment. Not everyone is capable of maxing out a 401k every year.

I might be biased since I took out a TSP loan to help with my down payment. I maxed contributions before and have continued to do so since taking the loan.
Last edited by Ketawa on Thu Jul 10, 2014 1:07 pm, edited 1 time in total.

assumer
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Re: Increase 401k Contribution Limits through Self Loans

Post by assumer » Thu Jul 10, 2014 1:04 pm

ERISA Stone wrote:
assumer wrote:I have a solo 401k through etrade.

They allow you to take a loan against yourself for up to $50k. They make you pay yourself back 1% or something.

If I take that full loan, and pay back on a regular schedule (as well as make my normal 401k contributions), I can essentially increase the amount of tax sheltered space I have in my 401k by an additional $500 / year, correct?
Are you sure eTrade didn't say prime +1%? The interest rate must be "reasonable" and I don't think 1% would fly if you were to get audited.
You might be right; I don't remember. The actual value is irrelevant though, my question is more about the concept and tax consequences regardless of what the actual percentage is.

livesoft
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Re: Increase 401k Contribution Limits through Self Loans

Post by livesoft » Thu Jul 10, 2014 1:21 pm

The terms of the loan are probably important. The max term of the loan we took was 4 years. Payments were automatically deducted from a paycheck, so the paycheck had to be large enough to support the loan payments.

Now I suppose with a solo 401(k) that one cannot lose their job, although they may lose their income. If in this situation one had a 401(k) and then had no income for a few months or a year, what happens? How is the loan paid? Or is the loan then considered a withdrawal with any penatlties and potential taxes due? What if one gets a job with another employer with a 401(k) with a huge match? What does one do with the loan then?
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