401(k) Loans

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
dunk1234
Posts: 8
Joined: Mon Sep 06, 2021 10:41 am

401(k) Loans

Post by dunk1234 »

I'm new to investing and to having a 401(k). So I had two related questions.

First: I have friends at work who are fond of taking loans from their 401(k)s and "paying the loan interest to themselves." I hear things like "that's how Ralph bought his X, Y, and Z (toys)." Friends make this out to be a win-win move. I believe it isn't. Could anyone help me articulate why this isn't win-win, and elucidate the costs of such activity? Thank you.

Second: Even though this 401(k) loan opportunity is not a "free lunch," could it possibly be used as a substitute for an emergency fund? My EF is currently held in a taxable account...

Thanks for any insights you might offer.
User avatar
Brianmcg321
Posts: 1503
Joined: Mon Jul 15, 2019 8:23 am

Re: 401(k) Loans

Post by Brianmcg321 »

Loans from 401k are terrible ideas. You're taking money out of the market. Its a lose, lose. Your friends need to learn how to budget their money better.

Another bad reason is if for some reason they lose their job, change jobs, get laid off, or if the company just changes hands, the loan is required to be payed back immediately or you pay a penalty on the withdrawal. I've seen more than a few people that got burned when the company changed hands a few times. People had taken out loans on their 401k and then literally a month later the company bought out by another company. That $40,000 truck they bought wasn't such a good idea.

No, it is not a substitute for an emergency fund. Stop playing games with your retirement money.
Rules to investing: | 1. Don't lose money. | 2. Don't forget rule number 1.
Topic Author
dunk1234
Posts: 8
Joined: Mon Sep 06, 2021 10:41 am

Re: 401(k) Loans

Post by dunk1234 »

Thanks Brianmcg321,

I understand from you that the two primary costs are a) loss of gains on investment, and b) risk of 10% withdrawal penalty.

From what you wrote, I can glean that 401(k) loans are risky as EF because a large reason for needing an EF is loss of employment...and obviously it would be costly to use 401(k) funds in such a case...

Appreciate the help.
khram
Posts: 271
Joined: Sat Dec 16, 2017 1:36 am

Re: 401(k) Loans

Post by khram »

In general, I think you can't contribute to your 401k until the loan is paid back, so you're also losing out on any 401k match during that time. If you get fired or quit, you have to pay it back right away (I'm guessing if you can't, it becomes a 401k withdrawal, subject to taxes + 10% penalty).

It's also a sign of living beyond your means. If you can't afford to max out your 401k, then don't. But don't rob your retirement every time you want a nicer house than you can afford or a fancy car, etc.
Topic Author
dunk1234
Posts: 8
Joined: Mon Sep 06, 2021 10:41 am

Re: 401(k) Loans

Post by dunk1234 »

khram wrote: Mon Sep 13, 2021 4:46 am
It's also a sign of living beyond your means.
Yes, and we have to be watchful of these signs. They creep.
User avatar
stickman731
Posts: 347
Joined: Sun Jan 01, 2012 10:42 am
Location: New Jersey

Re: 401(k) Loans

Post by stickman731 »

I generally agree with the other posters that it is a bad idea to take a 401K loan to buy "toys"; however, I did take a loan to purchase my first home to avoid a PMI. The PMI at the time equated to an additional 4+ % over its life and my 401K plan had a special "first-time home owner provision".

I do not recall all the details as it was 20 years ago and it worked out well.
Topic Author
dunk1234
Posts: 8
Joined: Mon Sep 06, 2021 10:41 am

Re: 401(k) Loans

Post by dunk1234 »

stickman731 wrote: Mon Sep 13, 2021 4:53 am I generally agree with the other posters that it is a bad idea to take a 401K loan to buy "toys"; however, I did take a loan to purchase my first home to avoid a PMI. The PMI at the time equated to an additional 4+ % over its life and my 401K plan had a special "first-time home owner provision".
I was more curious about the trade-offs between 401(k) loans and non-401(k) loans. I shouldn't have mentioned toys, that was misleading. Thank you for your input.
lakpr
Posts: 8162
Joined: Fri Mar 18, 2011 9:59 am

Re: 401(k) Loans

Post by lakpr »

Brianmcg321 wrote: Mon Sep 13, 2021 4:39 am Another bad reason is if for some reason they lose their job, change jobs, get laid off, or if the company just changes hands, the loan is required to be payed back immediately or you pay a penalty on the withdrawal.
Recent tax law changes allow the 401k loan money to be repaid by the tax deadline, not within 30 days of separation from employment, including extensions. That could give at least 9.5 months and potentially more, even if the person lost/retired/quit the job in December, until October 15th of next year. Only money not repaid by that deadline is deemed early withdrawal, and attract taxes + penalties.

I completely agree with the rest of the post.
livesoft
Posts: 77681
Joined: Thu Mar 01, 2007 8:00 pm

Re: 401(k) Loans

Post by livesoft »

I agree that 401(k) loans to increase one's spending beyond their means are a bad idea.

Nevertheless, my spouse took out a 401(k) loan in a specific situation to save some money. Here's how it went down:

At the time her 401(k) funds had high expense ratios, close to 2%. She had the money invested in a bond fund. So she took a $50K loan and the money was contributed to the 529 plans of our 2 children and invested in a bond fund with expense ratio around 0.1%. That is, the money was NOT spent, but was put into a tax-free investment. The interest on the loan was about the same as the yield on the bond funds. So in effect, it looked like she was saving the difference between the expense ratios of a bond fund inside the 401(k) and one inside a 529 plan.

That was working for a couple of years, so saved say about $2,000. But then her company was sold and her 401(k) loan was due in full. We used money from our taxable investments to pay off the 401(k) loan. She learned that a colleague had a 401(k) loan to build a house. Her colleague did not have the money to pay off their 401(k) loan and had to consider their loan a withdrawal, so they had to pay the 10% penalty and the taxes on their 401(k) withdrawal. Neither her colleague nor my spouse actually lost their jobs since they just became employees of the company that bought the company that they worked for, but their 401(k) loans had different financial outcomes: one relatively good and the other bad.

And one more thing: When her company was bought out, she was able to roll her full 401(k) over to a rollover IRA and invest in a Vanguard low-expense ratio index bond fund PLUS her new company's 401(k) plan soon changed to using Vanguard index funds instead of high expense ratio funds.
Last edited by livesoft on Mon Sep 13, 2021 5:28 am, edited 2 times in total.
Wiki This signature message sponsored by sscritic: Learn to fish.
harikaried
Posts: 1799
Joined: Fri Mar 09, 2012 3:47 pm

Re: 401(k) Loans

Post by harikaried »

dunk1234 wrote: Mon Sep 13, 2021 5:03 amI was more curious about the trade-offs between 401(k) loans and non-401(k) loans.
If one adjusts the asset allocation treating the 401k interest payments "to themselves" as a bond allocation, these repaid amounts can be higher than what bonds would have yielded resulting in a larger 401k balance. So the 401k interest "expense" shouldn't be directly compared to the interest on other loans.
User avatar
Brianmcg321
Posts: 1503
Joined: Mon Jul 15, 2019 8:23 am

Re: 401(k) Loans

Post by Brianmcg321 »

lakpr wrote: Mon Sep 13, 2021 5:13 am
Brianmcg321 wrote: Mon Sep 13, 2021 4:39 am Another bad reason is if for some reason they lose their job, change jobs, get laid off, or if the company just changes hands, the loan is required to be payed back immediately or you pay a penalty on the withdrawal.
Recent tax law changes allow the 401k loan money to be repaid by the tax deadline, not within 30 days of separation from employment, including extensions. That could give at least 9.5 months and potentially more, even if the person lost/retired/quit the job in December, until October 15th of next year. Only money not repaid by that deadline is deemed early withdrawal, and attract taxes + penalties.

I completely agree with the rest of the post.
That makes it worse. That will just entice more people to take out these loans. Just because they are allowed doesn't mean they are a good idea.

I think a lot of people think its a sophisticated use of money when you really are just robbing your 60 year old self of their money.
Rules to investing: | 1. Don't lose money. | 2. Don't forget rule number 1.
Topic Author
dunk1234
Posts: 8
Joined: Mon Sep 06, 2021 10:41 am

Re: 401(k) Loans

Post by dunk1234 »

Brianmcg321 wrote: Mon Sep 13, 2021 4:39 am


I think a lot of people think its a sophisticated use of money when you really are just robbing your 60 year old self of their money.
I like that Brianmcg321 is looking at the investor as two people, because he indeed is two people, at least!
User avatar
JoeRetire
Posts: 9281
Joined: Tue Jan 16, 2018 2:44 pm

Re: 401(k) Loans

Post by JoeRetire »

dunk1234 wrote: Mon Sep 13, 2021 4:36 am First: I have friends at work who are fond of taking loans from their 401(k)s and "paying the loan interest to themselves." I hear things like "that's how Ralph bought his X, Y, and Z (toys)." Friends make this out to be a win-win move. I believe it isn't. Could anyone help me articulate why this isn't win-win, and elucidate the costs of such activity?
401ks are tax deferred - a major advantage.
Yet you pay back a 401k loan with after tax money that will be taxed yet again once eventually withdrawn.

Bad idea.
Just remember: it's not a lie if you believe it.
User avatar
markjk
Posts: 225
Joined: Wed Oct 07, 2020 6:01 am

Re: 401(k) Loans

Post by markjk »

The 401k loan is financial tool that might be reasonable in the right situation. I experienced this through a family member when the 401k loan was a necessity to take care of a surprise (and very expensive) issue. It wasn't optimal for all the reasons described earlier but it was the best option at that time. If you can avoid using it, you should. But, it is there in a worst case scenario. I would not suggest planning to use a 401k loan for anything.
lakpr
Posts: 8162
Joined: Fri Mar 18, 2011 9:59 am

Re: 401(k) Loans

Post by lakpr »

JoeRetire wrote: Mon Sep 13, 2021 6:39 am Yet you pay back a 401k loan with after tax money that will be taxed yet again once eventually withdrawn.

Bad idea.
This is a fallacy. Yes you are repaying with after-tax dollars, but you weren't paying taxes on the distributions taken from the 401k loan either. So the money you will withdraw from the plan in retirement is taxed only once, 401k loans not withstanding.

Completely agree that 401k loan is a bad idea.
MrJedi
Posts: 1072
Joined: Wed May 06, 2020 11:42 am

Re: 401(k) Loans

Post by MrJedi »

I plan to use one as a bridge loan between houses in order to avoid selling taxable stocks that now have large gains embedded. In this case I would just use it as temporary cash source for a few months for a portion of the down payment on new house and then pay it back immediately after selling the old house. I think something like this might be a reasonable usage.
exodusNH
Posts: 770
Joined: Wed Jan 06, 2021 8:21 pm

Re: 401(k) Loans

Post by exodusNH »

lakpr wrote: Mon Sep 13, 2021 6:53 am
JoeRetire wrote: Mon Sep 13, 2021 6:39 am Yet you pay back a 401k loan with after tax money that will be taxed yet again once eventually withdrawn.

Bad idea.
This is a fallacy. Yes you are repaying with after-tax dollars, but you weren't paying taxes on the distributions taken from the 401k loan either. So the money you will withdraw from the plan in retirement is taxed only once, 401k loans not withstanding.

Completely agree that 401k loan is a bad idea.
Right, it's just the interest payments that wind up getting taxed twice.

The other cost is the loan administration fee.

I think the biggest danger is having to pay back potentially $1000s in a relatively short timeline.
User avatar
hand
Posts: 1742
Joined: Sun May 17, 2009 8:42 pm

Re: 401(k) Loans

Post by hand »

Key issues with 401(k) loans as follows:
1) May allow the unsophisticated to overconsume
2) May need to repay entire loan unexpectedly quickly in case of job loss (varies by plan)
3) If unable to repay loan, early withdrawal penalties apply
5) Mechanically challenging to take loan without changing your asset allocation (by default, you become more bond heavy)
6) Lose out of market returns during period of time you have the loan -- this may be substantially more than interest paid to a third party during the loan period

Personally, I'm torn as to the utility of these loans:

On one hand, they are very obviously financial poison to the large portion of the population who struggles to save for retirement appropriately and struggles with overconsuming.

On the other hand, they do seem like a useful tool for those who are "retirement account poor" and are in the position of having overcontributed to their retirement accounts at the expense of accessible funds.
Money_Badger
Posts: 141
Joined: Thu Jul 02, 2020 11:05 pm
Location: Raleigh NC

Re: 401(k) Loans

Post by Money_Badger »

MrJedi wrote: Mon Sep 13, 2021 9:05 am I plan to use one as a bridge loan between houses in order to avoid selling taxable stocks that now have large gains embedded. In this case I would just use it as temporary cash source for a few months for a portion of the down payment on new house and then pay it back immediately after selling the old house. I think something like this might be a reasonable usage.
I used a 401K loan to pay off some credit card debt that I had amassed over the years (I know ... I know). I paid off the loan quickly, got out from under a chunk of high interest credit card debt, and have stayed debt free since.
User avatar
willthrill81
Posts: 25552
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: 401(k) Loans

Post by willthrill81 »

Never do a 401k loan unless you absolutely have to. Many people who have had one lost their job and had to repay their loan within 60 days to avoid paying federal and state income taxes on the loan balance in addition to the 10% penalty. No thanks.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
exodusNH
Posts: 770
Joined: Wed Jan 06, 2021 8:21 pm

Re: 401(k) Loans

Post by exodusNH »

willthrill81 wrote: Mon Sep 13, 2021 10:42 am Never do a 401k loan unless you absolutely have to. Many people who have had one lost their job and had to repay their loan within 60 days to avoid paying federal and state income taxes on the loan balance in addition to the 10% penalty. No thanks.
This has changed to be due at the tax filing date (including extensions) rather than only 60 days.
User avatar
willthrill81
Posts: 25552
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: 401(k) Loans

Post by willthrill81 »

exodusNH wrote: Mon Sep 13, 2021 10:47 am
willthrill81 wrote: Mon Sep 13, 2021 10:42 am Never do a 401k loan unless you absolutely have to. Many people who have had one lost their job and had to repay their loan within 60 days to avoid paying federal and state income taxes on the loan balance in addition to the 10% penalty. No thanks.
This has changed to be due at the tax filing date (including extensions) rather than only 60 days.
That's far better than the way it used to be.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
User avatar
JoeRetire
Posts: 9281
Joined: Tue Jan 16, 2018 2:44 pm

Re: 401(k) Loans

Post by JoeRetire »

lakpr wrote: Mon Sep 13, 2021 6:53 am
JoeRetire wrote: Mon Sep 13, 2021 6:39 am Yet you pay back a 401k loan with after tax money that will be taxed yet again once eventually withdrawn.

Bad idea.
This is a fallacy. Yes you are repaying with after-tax dollars, but you weren't paying taxes on the distributions taken from the 401k loan either. So the money you will withdraw from the plan in retirement is taxed only once, 401k loans not withstanding.
The distribution from the loan wasn't taxed.

The money you use to repay the loan is taxed.
Once you eventually withdraw money (including the repaid loan amount) from the 401k it is taxed.

The repaid portion is taxed twice.
Just remember: it's not a lie if you believe it.
harikaried
Posts: 1799
Joined: Fri Mar 09, 2012 3:47 pm

Re: 401(k) Loans

Post by harikaried »

JoeRetire wrote: Mon Sep 13, 2021 11:12 amThe repaid portion is taxed twice.
What happens if you take a $50k 401k loan then decide you didn't actually need it, so you repay the $50k with the money just taken out?
BogleHead1008
Posts: 144
Joined: Fri Jul 23, 2021 8:44 am

Re: 401(k) Loans

Post by BogleHead1008 »

harikaried wrote: Mon Sep 13, 2021 11:42 am
JoeRetire wrote: Mon Sep 13, 2021 11:12 amThe repaid portion is taxed twice.
What happens if you take a $50k 401k loan then decide you didn't actually need it, so you repay the $50k with the money just taken out?
You can repay anytime you want, but you will have to eat the fees, fees for setting up the loan and quarterly loan and any interest accumulated on the loan.
User avatar
JoeRetire
Posts: 9281
Joined: Tue Jan 16, 2018 2:44 pm

Re: 401(k) Loans

Post by JoeRetire »

harikaried wrote: Mon Sep 13, 2021 11:42 am
JoeRetire wrote: Mon Sep 13, 2021 11:12 amThe repaid portion is taxed twice.
What happens if you take a $50k 401k loan then decide you didn't actually need it, so you repay the $50k with the money just taken out?
In that case, that $50k is only taxed once. Any accumulated interest is still paid with after tax money, so that portion is taxed twice.

Think that happens often? Do many people actually take loans they don't need? Maybe I'm giving borrowers too much credit?
Just remember: it's not a lie if you believe it.
lakpr
Posts: 8162
Joined: Fri Mar 18, 2011 9:59 am

Re: 401(k) Loans

Post by lakpr »

JoeRetire wrote: Mon Sep 13, 2021 11:45 am
harikaried wrote: Mon Sep 13, 2021 11:42 am
JoeRetire wrote: Mon Sep 13, 2021 11:12 amThe repaid portion is taxed twice.
What happens if you take a $50k 401k loan then decide you didn't actually need it, so you repay the $50k with the money just taken out?
In that case, that $50k is only taxed once. Any accumulated interest is still paid with after tax money, so that portion is taxed twice.

Think that happens often? Do many people actually take loans they don't need? Maybe I'm giving borrowers too much credit?
The point that @harakiried is making is that there is no difference in repayment of the principal; whether it is at once or over time. You yourself agreed that the $50k is taxed only once.

The *interest you pay* on the 401k loan, is indeed taxed twice. You are paying the interest with after-tax dollars, and when those dollars are taken out of the 401k plan, they are taxed as ordinary income and taxed again. But the principal itself? Nah ...
Raraculus
Posts: 133
Joined: Sat Jul 20, 2019 10:43 am

Re: 401(k) Loans

Post by Raraculus »

hand wrote: Mon Sep 13, 2021 9:48 amOn the other hand, they do seem like a useful tool for those who are "retirement account poor" and are in the position of having overcontributed to their retirement accounts at the expense of accessible funds.
This fits me to a T!

For the first time this year, I am on track in maxing out my retirement account contributions. This has reduced my take-home pay considerably. This past summer was a huge challenge, as I had to pay off one expiring CC and two other huge CC payments. It feels like I'm on some financial high-wire act, and it's a struggle to stay balanced. I literally had to wait for my recent payday to pay off one CC. My brokerage account has stalled - it has barely grown over the summer.

I am tempted to borrow from my 401(k) and stash the proceeds in my brokerage account. It'll give me a cushion so I don't have to tight-rope it next summer. I did talk with the 401(k) people and they said I would be able to continue my contributions while the 401(k) loan is under repayment. The high interest rate gives me pause and the fact they'll deduct loan repayments from my payroll.

So... Not sure what to do. I'm okay for the time being. Hopefully my brokerage account will grow further until next summer and maybe I don't have to worry about it anymore.
knowledge
Posts: 362
Joined: Wed Mar 02, 2011 5:44 pm

Re: 401(k) Loans

Post by knowledge »

Used smartly, 401k loans have some utility. I pulled one to fund a down payment to buy before I sold my prior home and without resorting to realizing taxable gains. Given the 6.5% interest rate, I felt fine doing so. In hindsight, I think it worked out ok and faced with a similar circumstance I would do it again.

But it wouldn't surprise me to hear that tapping a 401k loan is a sign of someone who is overextended, 9 times out of 10.
User avatar
hand
Posts: 1742
Joined: Sun May 17, 2009 8:42 pm

Re: 401(k) Loans

Post by hand »

Raraculus wrote: Mon Sep 13, 2021 12:43 pm
hand wrote: Mon Sep 13, 2021 9:48 amOn the other hand, they do seem like a useful tool for those who are "retirement account poor" and are in the position of having overcontributed to their retirement accounts at the expense of accessible funds.
This fits me to a T!

For the first time this year, I am on track in maxing out my retirement account contributions. This has reduced my take-home pay considerably. This past summer was a huge challenge, as I had to pay off one expiring CC and two other huge CC payments. It feels like I'm on some financial high-wire act, and it's a struggle to stay balanced. I literally had to wait for my recent payday to pay off one CC. My brokerage account has stalled - it has barely grown over the summer.

I am tempted to borrow from my 401(k) and stash the proceeds in my brokerage account. It'll give me a cushion so I don't have to tight-rope it next summer. I did talk with the 401(k) people and they said I would be able to continue my contributions while the 401(k) loan is under repayment. The high interest rate gives me pause and the fact they'll deduct loan repayments from my payroll.

So... Not sure what to do. I'm okay for the time being. Hopefully my brokerage account will grow further until next summer and maybe I don't have to worry about it anymore.

Congrats on maxing your retirement account contributions! For the record, my quote on overcontributing was more focused on having a higher retirement account balance than required for your desired retirement spending and your age.

I don't know your financial situation, but typically credit card payment challenges are more about structural overspending than retirement overcontributions... In your case I would be very cautious about risking retirement assets to address a credit-card challenge. If you have a taxable brokerage account, this is likely much better suited to pay your credit card debt.

Apologies for derailing the thread, but hated the idea of you taking my comments as justification to borrow from your retirement account. I'd recommend starting a separate thread to get community input on your financial situation and best ways to get off the high wire.
exodusNH
Posts: 770
Joined: Wed Jan 06, 2021 8:21 pm

Re: 401(k) Loans

Post by exodusNH »

JoeRetire wrote: Mon Sep 13, 2021 11:12 am
lakpr wrote: Mon Sep 13, 2021 6:53 am
JoeRetire wrote: Mon Sep 13, 2021 6:39 am Yet you pay back a 401k loan with after tax money that will be taxed yet again once eventually withdrawn.

Bad idea.
This is a fallacy. Yes you are repaying with after-tax dollars, but you weren't paying taxes on the distributions taken from the 401k loan either. So the money you will withdraw from the plan in retirement is taxed only once, 401k loans not withstanding.
The distribution from the loan wasn't taxed.

The money you use to repay the loan is taxed.
Once you eventually withdraw money (including the repaid loan amount) from the 401k it is taxed.

The repaid portion is taxed twice.
No, the interest is taxed twice.

You put in the money without paying taxes.

You take the money out without paying taxes on the distribution.

When you repay the loan, you are doing so with "after-tax" money because you already got the tax deduction. Of course, if the money went in when you were at the 22% bracket and you're now paying it back from the 24% bracket, you're losing out a bit.

You pay the interest with after-tax money as well. When you take your withdrawals, you will pay ordinary income rates on the interest and whatever it's grown to. This is the only money that's double-taxed. But that money has had the opportunity to grow and be rebalanced without tax concerns.
TropikThunder
Posts: 3070
Joined: Sun Apr 03, 2016 5:41 pm

Re: 401(k) Loans

Post by TropikThunder »

willthrill81 wrote: Mon Sep 13, 2021 10:59 am
exodusNH wrote: Mon Sep 13, 2021 10:47 am
willthrill81 wrote: Mon Sep 13, 2021 10:42 am Never do a 401k loan unless you absolutely have to. Many people who have had one lost their job and had to repay their loan within 60 days to avoid paying federal and state income taxes on the loan balance in addition to the 10% penalty. No thanks.
This has changed to be due at the tax filing date (including extensions) rather than only 60 days.
That's far better than the way it used to be.
Some plans also allow you to continue making payments under the original terms even if you separate from employment (mine does). Some plans also allow the loan collateral to remain invested, in my case in the TIAA Traditional annuity paying a guaranteed 3.00% interest. So that money is not out of the market, it’s in my fixed income allocation.

401k loans are not the horror story so many commenters repeatedly say they are. They same posters always make the same uninformed criticisms on every 401k loan thread, despite being repeatedly corrected. As with any tool, the can be used properly or they can be used improperly.

The wisdom of borrowing from your retirement account is a topic for legitimate debate but that debate is undermined by misinformation. They’re certainly better than pulling out Roth contributions since at least the 401k loan can be put back - you can never replace withdrawn Roth contributions, that space is gone forever. IMO the only good reason to take one is to increase a home down payment enough to avoid PMI (that’s what I did) but saying they’re a blanket “horrible idea” is myopic.
Last edited by TropikThunder on Mon Sep 13, 2021 2:14 pm, edited 2 times in total.
TropikThunder
Posts: 3070
Joined: Sun Apr 03, 2016 5:41 pm

Re: 401(k) Loans

Post by TropikThunder »

exodusNH wrote: Mon Sep 13, 2021 1:42 pm You pay the interest with after-tax money as well. When you take your withdrawals, you will pay ordinary income rates on the interest and whatever it's grown to. This is the only money that's double-taxed. But that money has had the opportunity to grow and be rebalanced without tax concerns.
+1. You’d be paying back a conventional loan with after-tax money too, so that’s a wash.
User avatar
grabiner
Advisory Board
Posts: 30406
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: 401(k) Loans

Post by grabiner »

It's easiest to see that double taxation isn't much of an issue by working out an example with numbers.

Suppose that you take out a one-year, $10,000 loan from your 401(k) at a 3% rate, withdrawing money that was in a bond fund yielding 3%. Next year, you must put $10,300 back, and you would have had $10,300 in the 401(k) without the loan. Thus, in this example, you paid 3% non-deductible interest, and it doesn't matter whether the 401(k) is traditional or Roth.

Double taxation is an extra cost if the loan rate is higher than the bond yield. Consider the example above, but with the bond fund yielding 2%. Next year, you must put $10,300 back. If you had left the money in the 401(k), it would have grown to $10,200. If your 401(k) is a Roth 401(k), then you would have had to contribute an extra $100 to the 401(k) to get the same $10,300 balance, so the net interest cost was only the 2% bond yield. If your 401(k) is a traditional 401(k0, then you would have had to contribute an extra $78 out of pocket to put $100 in the 401(k), so the net interest cost on the loan was $222, for a 2.22% rather than 2% effective rate.

(You don't have to take your 401(k) loan from your bond fund, but this makes the comparison simpler. If you take your loan from a stock fund, you reduce both expected returns and risk, presumably at a fair trade-off.)
Wiki David Grabiner
User avatar
willthrill81
Posts: 25552
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: 401(k) Loans

Post by willthrill81 »

TropikThunder wrote: Mon Sep 13, 2021 2:08 pmIMO the only good reason to take one is to increase a home down payment enough to avoid PMI (that’s what I did) but saying they’re a blanket “horrible idea” is myopic.
If there is only one plausible reason for taking out a 401k loan, then a blanket statement against making them doesn't seem all that myopic to me.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
ChrisRx
Posts: 31
Joined: Fri Jan 03, 2020 10:33 pm

Re: 401(k) Loans

Post by ChrisRx »

I think it's a great idea to take out a 401k...

If my kids are starving! :o
placeholder
Posts: 4984
Joined: Tue Aug 06, 2013 12:43 pm

Re: 401(k) Loans

Post by placeholder »

khram wrote: Mon Sep 13, 2021 4:46 am In general, I think you can't contribute to your 401k until the loan is paid back,
Where is the evidence that this is generally true because it sure wasn't at megacorp when I worked there.
placeholder
Posts: 4984
Joined: Tue Aug 06, 2013 12:43 pm

Re: 401(k) Loans

Post by placeholder »

Brianmcg321 wrote: Mon Sep 13, 2021 4:39 am Loans from 401k are terrible ideas. You're taking money out of the market.
Not if you take the money exclusively from fixed income and consider the loan in that allocation going forward.
MrJedi
Posts: 1072
Joined: Wed May 06, 2020 11:42 am

Re: 401(k) Loans

Post by MrJedi »

placeholder wrote: Wed Sep 15, 2021 1:25 am
khram wrote: Mon Sep 13, 2021 4:46 am In general, I think you can't contribute to your 401k until the loan is paid back,
Where is the evidence that this is generally true because it sure wasn't at megacorp when I worked there.
Missed this earlier. I agree not generally true at all. This is plan specific. I can still contribute and receive match on my plan with a loan out.
Raraculus
Posts: 133
Joined: Sat Jul 20, 2019 10:43 am

Re: 401(k) Loans

Post by Raraculus »

hand wrote: Mon Sep 13, 2021 1:31 pmApologies for derailing the thread, but hated the idea of you taking my comments as justification to borrow from your retirement account. I'd recommend starting a separate thread to get community input on your financial situation and best ways to get off the high wire.
My apologies for gently hijacking this thread. I hate to create a top-level post and call attention to my first world financial problems. :D

In case if I wasn't clear, I do not have a 401(k) loan. However, I was looking into it recently, and this thread been a timely source! I learned quite a bit about the pros/cons of having a 401(k) loan.

One thing I learned in this thread was about the double taxation of interest payments on the 401(k) loan. I crunched some numbers and due to my higher tax bracket, I would be paying roughly 1.6% more in interest than the stated interest rate. This has brought up a potential 401(k) loan to a higher repayment amount than I had anticipated. They would be taxed again when I start distributions... That was a bit too much.

So, I've decided not to pursue a 401(k) loan. I'll have to look elsewhere.
jstorz
Posts: 41
Joined: Fri Sep 04, 2020 5:44 pm

Re: 401(k) Loans

Post by jstorz »

Raraculus wrote: Wed Sep 15, 2021 1:54 pm One thing I learned in this thread was about the double taxation of interest payments on the 401(k) loan.
From your 401k's perspective it has loaned out money and the interest coming back is taxable interest. Put a different way: if you loaned someone money, you would be taxed on any interest they paid you. And if you borrow from another source, you will usually pay the interest expense with your after-tax dollars.

So while it is technically "double taxed" if it goes back into pre-tax balances, that is not quite the full story.
exodusNH
Posts: 770
Joined: Wed Jan 06, 2021 8:21 pm

Re: 401(k) Loans

Post by exodusNH »

placeholder wrote: Wed Sep 15, 2021 1:25 am
khram wrote: Mon Sep 13, 2021 4:46 am In general, I think you can't contribute to your 401k until the loan is paid back,
Where is the evidence that this is generally true because it sure wasn't at megacorp when I worked there.
It depends on how the plan was set up. I have no idea what percent are like this. Plans can have restrictions that aren't IRS-imposed. (E.g. contribution limits below what the IRS allows.)
exodusNH
Posts: 770
Joined: Wed Jan 06, 2021 8:21 pm

Re: 401(k) Loans

Post by exodusNH »

Raraculus wrote: Wed Sep 15, 2021 1:54 pm
hand wrote: Mon Sep 13, 2021 1:31 pmApologies for derailing the thread, but hated the idea of you taking my comments as justification to borrow from your retirement account. I'd recommend starting a separate thread to get community input on your financial situation and best ways to get off the high wire.
My apologies for gently hijacking this thread. I hate to create a top-level post and call attention to my first world financial problems. :D

In case if I wasn't clear, I do not have a 401(k) loan. However, I was looking into it recently, and this thread been a timely source! I learned quite a bit about the pros/cons of having a 401(k) loan.

One thing I learned in this thread was about the double taxation of interest payments on the 401(k) loan. I crunched some numbers and due to my higher tax bracket, I would be paying roughly 1.6% more in interest than the stated interest rate. This has brought up a potential 401(k) loan to a higher repayment amount than I had anticipated. They would be taxed again when I start distributions... That was a bit too much.

So, I've decided not to pursue a 401(k) loan. I'll have to look elsewhere.
It's double taxed from the perspective that

a) you're paying the 401k loan back + interest with after-tax money. (This is only fair since the money went in with a tax break.)
b) the interest paid into the 401k isn't tracked -- it just goes in the pot. When you withdraw from the 401k, you are paying taxes on the interest paid in. In the scope of a lifetime of savings, this probably isn't all much. E.g., if you paid in $1000 of interest, and you're in the 25% bracket, you'll pay an additional $250 in tax years from now. That may very well be less than the interest you'd have paid on the loan or even the fees.

401k loans may have an initial fee and a monthly/quarterly fee while the loan is outstanding. But that loan doesn't affect your credit score, and if used for something like avoiding PMI, might net positive.

The danger with 401k loans is

a) behavioral - you are living beyond your means
b) market risk - take the loan when the market is down and repay it when it's high
c) some plans may prevent new contributions until the loan is paid off
d) repayment risk if you change employers

But if you're confident in your ability to pay back the loan in a reasonable amount of time, c) isn't an issue, and you're not using it for frivolous purposes (which is in the eye of the beholder), they can be an OK idea.
260chrisb
Posts: 869
Joined: Wed Apr 28, 2010 7:26 pm

Re: 401(k) Loans

Post by 260chrisb »

dunk1234 wrote: Mon Sep 13, 2021 4:36 am I'm new to investing and to having a 401(k). So I had two related questions.

First: I have friends at work who are fond of taking loans from their 401(k)s and "paying the loan interest to themselves." I hear things like "that's how Ralph bought his X, Y, and Z (toys)." Friends make this out to be a win-win move. I believe it isn't. Could anyone help me articulate why this isn't win-win, and elucidate the costs of such activity? Thank you.

Second: Even though this 401(k) loan opportunity is not a "free lunch," could it possibly be used as a substitute for an emergency fund? My EF is currently held in a taxable account...

Thanks for any insights you might offer.
Plenty of good advice has been offered and I hope you take some. The bottom line is you should never take a loan from a 401K unless it's a matter of life or death, you should NEVER use any retirement account as an emergency fund (or fund one with the possible intent), and you should NEVER listen to your dumbass friends who are doing dumb things with their money and will likely always be broke!
placeholder
Posts: 4984
Joined: Tue Aug 06, 2013 12:43 pm

Re: 401(k) Loans

Post by placeholder »

exodusNH wrote: Tue Sep 21, 2021 4:56 pm
placeholder wrote: Wed Sep 15, 2021 1:25 am
khram wrote: Mon Sep 13, 2021 4:46 am In general, I think you can't contribute to your 401k until the loan is paid back,
Where is the evidence that this is generally true because it sure wasn't at megacorp when I worked there.
It depends on how the plan was set up. I have no idea what percent are like this. Plans can have restrictions that aren't IRS-imposed. (E.g. contribution limits below what the IRS allows.)
That's true but not an answer to the question asked.
TropikThunder
Posts: 3070
Joined: Sun Apr 03, 2016 5:41 pm

Re: 401(k) Loans

Post by TropikThunder »

placeholder wrote: Wed Sep 15, 2021 1:25 am
khram wrote: Mon Sep 13, 2021 4:46 am In general, I think you can't contribute to your 401k until the loan is paid back,
Where is the evidence that this is generally true because it sure wasn't at megacorp when I worked there.
I must have caught a unicorn then. I took a 403b loan from my TIAA account for a down payment. The loan amount is still invested (in a Traditional account earning 3% interest itself) which I include as part of my fixed income allocation although I can’t use it for rebalancing; I can still make contributions and receive a match; and if I leave my employer I can continue making monthly payments under the current terms. I haven’t found the downside yet.
User avatar
JoMoney
Posts: 12050
Joined: Tue Jul 23, 2013 5:31 am

Re: 401(k) Loans

Post by JoMoney »

401k Loans can be a better choice than borrowing money elsewhere, but in most cases people would be better off not borrowing at all.
It's usually a sign that someone isn't "living below their means", you're not going to accumulate wealth if you can't save money.

Aside from the money not being able to continue to grow for your retirement if you withdraw it, there are steep penalties if you leave your job and don't pay the 401k loan in full immediately. The "loan" will be treated as a withdrawal, and be taxed at your top tax rate (federal and state) plus a 10% federal penalty, in California the state will tack an extra 2.5% penalty on as well.
For someone in a 22% federal bracket that could mean:
22% Federal Income tax
+ 9.3% California State Income tax
+ 10% Federal early withdrawal penalty
+ 2.5% California early withdrawal penalty

That's > 40% gone to taxes, which would have otherwise likely come out at a very low rate if it was your only income in retirement/qualified withdrawal.

Also of note, the interest (and the principal) you pay back to the 401k (to yourself) comes out of your after-tax paycheck, but is treated as pre-tax money inside the 401k, and when you withdraw that interest in retirement you'll pay tax on it again :annoyed
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
User avatar
meowcat
Posts: 563
Joined: Wed May 09, 2012 5:46 am

Re: 401(k) Loans

Post by meowcat »

260chrisb wrote: Tue Sep 21, 2021 5:55 pm
dunk1234 wrote: Mon Sep 13, 2021 4:36 am I'm new to investing and to having a 401(k). So I had two related questions.

First: I have friends at work who are fond of taking loans from their 401(k)s and "paying the loan interest to themselves." I hear things like "that's how Ralph bought his X, Y, and Z (toys)." Friends make this out to be a win-win move. I believe it isn't. Could anyone help me articulate why this isn't win-win, and elucidate the costs of such activity? Thank you.

Second: Even though this 401(k) loan opportunity is not a "free lunch," could it possibly be used as a substitute for an emergency fund? My EF is currently held in a taxable account...

Thanks for any insights you might offer.
Plenty of good advice has been offered and I hope you take some. The bottom line is you should never take a loan from a 401K unless it's a matter of life or death, you should NEVER use any retirement account as an emergency fund (or fund one with the possible intent), and you should NEVER listen to your dumbass friends who are doing dumb things with their money and will likely always be broke!
I couldn't have said it better. :sharebeer
I don't eat ramen noodles because I'm poor. No, I'm rich because I eat ramen noodles. | -moewcat
Post Reply