is a 401k loan always terrible?

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jsa307
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is a 401k loan always terrible?

Post by jsa307 » Sun Jan 15, 2017 1:47 pm

I know 401k loans are frowned on here, but I'm trying to understand what would be so terrible about doing it. Brief background:

My wife and I are 2 young physicians living in a very HCOL area. We just started making a pretty good salary together (about 700k), and have spent the last year paying off 75% of my wife's student loans. All that's left now is the low interest loan - 50k @ 2.5%. We were going to pay that off in the first half of this year, but just found out that we're expecting our second child. While we could theoretically accommodate another kid in our house as is, it would much easier if we completed a renovation (likely cost 75k), which were planning to do next year anyway. We have about 75k as emergency $$, but it would take the first half of this year to accumulate the extra 75k needed for the renovation. At that point, it would be way too late to help out with having the new child and visiting family. If we took the $ from the 401k, however, we could set the term to a year and easily service that loan- while also paying off the student loan by the end of the year. I know we'd be losing the compounded interest of having that money in the fund, but even if that were 2-3k, i think both of us would think it's worth it to have a more comfortable living situation when the baby is born. Either of us losing our job within the year the loan is outstanding seems extremely remote. Plus I'd rather be paying the interest back to myself than some sort of financing arrangement. So is it always a terrible idea to take out a 401k loan? Other thoughts? Thanks for the advice!

DSInvestor
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Re: is a 401k loan always terrible?

Post by DSInvestor » Sun Jan 15, 2017 1:55 pm

With 700K gross income, I'm surprised you're not able to pay for the renovation with cash flow. You can decide whether you want the reno more than the accelerated payoff of student loans. I would not borrow from 401k.
Last edited by DSInvestor on Sun Jan 15, 2017 1:59 pm, edited 1 time in total.
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livesoft
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Re: is a 401k loan always terrible?

Post by livesoft » Sun Jan 15, 2017 1:58 pm

A 401(k) loan is not always terrible, but it is also limited in size to the less of $50K or half the amount in the 401(k). So to have $100K in a 401(k) when contribution limits have been $18K and less means maybe 3.5 years of contributions in recent years.

Visiting family can live in a hotel. :)
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ved
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Re: is a 401k loan always terrible?

Post by ved » Sun Jan 15, 2017 2:01 pm

If the chances of job loss is very remote, why don't you use a substantial portion of your emergency fund for the remodel.
You can have a HELOC/ credit card/ taxable investments as a back-up emergency fund.

stuben
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Re: is a 401k loan always terrible?

Post by stuben » Sun Jan 15, 2017 2:05 pm

I doubt you'll be able to borrow $75K from your 401K. Most plans will only allow you to borrow up to half of your account's balance and no more than $50K total.

Not borrowing from your 401K is one of the "sacred cows" of personal finance. However, it's not the worst way to pay for a home renovation. You have several things going for you that make this more practicable.

1) You have an incredibly high income.

2) You'll be reinvesting the proceeds into your home vs. blowing it on a vacation/car, etc.

3) It sounds like it will significantly improve your quality of life.

4) You're looking at a very short term finance.

5) You have a strong emergency fund in place.

Is a home equity loan an option for you?

jsa307
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Re: is a 401k loan always terrible?

Post by jsa307 » Sun Jan 15, 2017 2:12 pm

thanks for all the replies already! addressing some of the points raised:
-cash flow is not small, maybe 12-13k/month- averaged over the year. but starting from $0, it would be too late to accumulate the money, then do the project- before having the child
-yes the loan would be capped at 50K, but that would get us most of the way there
-can't do a HELOC, just purchased last year
-we both really dont want to touch the emergency fund

livesoft
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Re: is a 401k loan always terrible?

Post by livesoft » Sun Jan 15, 2017 2:18 pm

Presumably, there are two 401(k)s, so if enough money in them, getting $75K should not be problem. And if the loans need to be paid back quickly, there is the emergency fund for that.
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DSInvestor
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Re: is a 401k loan always terrible?

Post by DSInvestor » Sun Jan 15, 2017 2:18 pm

You have 50K loan 2.5% loan outstanding that you're planning to pay off in 6 months, that's at least 8K/month. What if you just made minimum payments on that loan for now and direct that money to the renovation? Between that cash flow and dipping a little into E-Fund, you've got it. If you have 12-13K/month cash flow with the loan payments, you'd have 20K/month if you stopped attacking the loan.
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dm200
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Re: is a 401k loan always terrible?

Post by dm200 » Sun Jan 15, 2017 3:16 pm

In my opinion, a big problem or confusion about 401k "loans" is that they are really not actually "loans". if you get one, it is important to understand this. When you get a 401k "loan", the amount disbursed actually comes from liquidating that amount of the investments in the 401k. Then, as you pay back, the investments are purchased. This is completely different than getting a margin loan from a broker where you still hold the underlying investments.

livesoft
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Re: is a 401k loan always terrible?

Post by livesoft » Sun Jan 15, 2017 3:20 pm

401(k) loans have specified pay-off mechanisms, so one has to research those and make sure that there are no "gotchas" there. For instance, loans are paid from paychecks and there may be no mechanism to make an extra payment from outside money. I am told that 401(k) custodians may not allow 401(k) contributions while a loan is outstanding, but that was not the case with my spouse's 401(k) loan.
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Eagle4Life
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Re: is a 401k loan always terrible?

Post by Eagle4Life » Sun Jan 15, 2017 3:52 pm

If you can't live off 700K, or even a quarter of that, and have the need to take any kind of loan, you are doing something wrong in life.

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Toons
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Re: is a 401k loan always terrible?

Post by Toons » Sun Jan 15, 2017 4:01 pm

While we could theoretically accommodate another kid in our house as is

Do that.
Pay off all the debt.
Do not borrow from the 401k.
Save for the home improvement.
4 easy steps
:mrgreen:
"One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity" –Bruce Lee

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jimb_fromATL
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Re: is a 401k loan always terrible?

Post by jimb_fromATL » Sun Jan 15, 2017 4:21 pm

Bad idea to rob the 401(k) for something like that project. IMO you need to either stop paying off other debts so fast, or borrow the money elsewhere, or not do the project until you can pay cash for it.

While most folks think it can never happen to them, a big danger with a 401(k) loan is that if they change jobs for any reason, the loan usually comes due immediately -- typically within about 60 days. If you don't pay it, the IRS considers it to be an early withdrawal, subject to income tax in your highest federal (and state) tax brackets plus the 10% penalty for early withdrawal. If that happens, the loss of taxes plus the loss of time for earning compound interest on the money --that is no longer in the 401(k) and cannot ever be put back-- can be astounding.

While it may not apply to you since you don't have equity, a home equity loan would usually be tax deductible for people in HCOL areas, and would effectively reduce the interest rate on the loan to less than you'd have to pay yourself back on the 401(k) loan.

Even if there's no danger at all about losing a job, unless you have a working crystal ball that can guarantee that your 401(k) is going to perform poorly --earning less than you're paying in interest on the loan during the term of the loan -- you'll probably end up losing money in the long run.

Here's an example to illustrate the problem:
  • Suppose you could get a personal loan at a credit union for $50,000 at 4.75% for 60 months. The payment would be $937.85. The total interest would be $6271.

    A typical 401(k) loan rate is the prime rate plus 1%. So if you borrowed the money from your 401(k) and paid yourself back at 4.75% the payment would be $937.85. Assuming the payments are reinvested immediately in the funds in the 401(k) and earn an average of 8%, the $937.85 payment per month will give you $68,910 in your account after 60 months.

    If you left the entire$50,000 in a lump sum in a 401(k) earning an average of 8% it would grow to $74,492 in the same 60 months earning $24,492. So you're short by about $5,582 in the 401(k) after 60 months.

    Assuming the same 8% earnings, and 30 more years until retirement, the $68,909 would grow to $753,570. But the $74,492 you'd have if you had left the 401(k) alone would grow to $814,624. So at retirement time you come up with $61,054 less money in the account in exchange for saving $6271 in interest on a commercial loan.

But wait...there's more. Earning a very conservative 4% after retirement, that $61,054 could pay you $291 per month for 30 years before it was all gone. So if you lived for 30 more years, you could lose 360 x $291 = $104,934 of future retirement income. Not a very good deal in the long run in exchange for saving $6271 on the debt in the short run.

If you were able to earn more nearly the long term historical averages in the stock market, the potential loss could run into some real money.

Even if you paid back the 401(k) loan in a year, the loss of future retirement income under the circumstances described above could cost you about $9 to $10 out of your retirement income for every dollar you save from avoiding a commercial loan.

... And if you can afford to pay back the loan in a year, all the more reason just to set them money aside and do the project when you can pay cash -- and leave the 401(k) alone.

jimb

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Re: is a 401k loan always terrible?

Post by flybynite » Sun Jan 15, 2017 4:48 pm

Toons wrote:While we could theoretically accommodate another kid in our house as is

Do that.
Pay off all the debt.
Do not borrow from the 401k.
Save for the home improvement.
4 easy steps
:mrgreen:
In a slightly nicer tone, I agree generally with this sentiment. I have 4 kids in a 3 bedroom townhouse, the oldest of which is a junior in high school. My guess is your baby nor you will be disappointed with the extra close proximity for an extra year until you can afford the project w/o severely impacting your retirement. I would personally squash spending a bit or leverage the emergency fund slightly (and replenish the next year since you are dual income this is not as concerning as it would be for me) if I really wanted to do it a bit earlier.

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Re: is a 401k loan always terrible?

Post by Caduceus » Sun Jan 15, 2017 5:44 pm

401k loans are perfectly fine, depending on how you're using them. This is a classic case of framing bias.

Two years ago if you had decided you were going to save that money in a taxable account for a home renovation, you would have sacrificed the tax-deferred 401k space and could not get it back. Putting the money into the 401k, and then taking it out as a loan now (and then paying it back in a short period of time) preserves the tax-advantaged space, wihich is better than never putting it there in the first place in anticipation of your housing goals.

Using 401k loans to pay off high-interest credit card debt is also usually a great idea. (Not having credit card debt or desires to upgrade housing would be even better, but assuming those are non-negotiable and the question is how to finance the goal, using a 401k is not the worst idea in the world.)

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sergeant
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Re: is a 401k loan always terrible?

Post by sergeant » Sun Jan 15, 2017 5:49 pm

I had a friend ask me if he should take a loan out of his 457b account. I told him it was a bad idea. He took the loan anyways. A couple months later the market tanked. He paid it off, back into his account over the next few years as the market recovered. His loan ended up working out pretty good for him.
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jlawrence01
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Re: is a 401k loan always terrible?

Post by jlawrence01 » Sun Jan 15, 2017 6:06 pm

sergeant wrote:I had a friend ask me if he should take a loan out of his 457b account. I told him it was a bad idea. He took the loan anyways. A couple months later the market tanked. He paid it off, back into his account over the next few years as the market recovered. His loan ended up working out pretty good for him.
And I have had employees take $25k from their 401(k) planning to pay it off in 12 months. Unfortunately, the economy tanked in 2008 and they were laid off. They were UNABLE to repay the loan and they were socked with the taxes and penalties.

There are a lot better ways of doing it.

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Ketawa
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Re: is a 401k loan always terrible?

Post by Ketawa » Sun Jan 15, 2017 6:27 pm

Caduceus wrote:401k loans are perfectly fine, depending on how you're using them. This is a classic case of framing bias.

Two years ago if you had decided you were going to save that money in a taxable account for a home renovation, you would have sacrificed the tax-deferred 401k space and could not get it back. Putting the money into the 401k, and then taking it out as a loan now (and then paying it back in a short period of time) preserves the tax-advantaged space, wihich is better than never putting it there in the first place in anticipation of your housing goals.

Using 401k loans to pay off high-interest credit card debt is also usually a great idea. (Not having credit card debt or desires to upgrade housing would be even better, but assuming those are non-negotiable and the question is how to finance the goal, using a 401k is not the worst idea in the world.)
+1. 401k loans are not terrible in themselves. Would an investor be better off saving for a legitimate expensive purchase in a taxable account while giving up tax-advantaged space? No.

Personally, I used a TSP loan to pay for my home's down payment. I was able to put down 10%, which allowed me to avoid the VA loan funding fee, paying points on a mortgage, and PMI. I still maxed my TSP every year.

cherijoh
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Re: is a 401k loan always terrible?

Post by cherijoh » Sun Jan 15, 2017 9:51 pm

Caduceus wrote:401k loans are perfectly fine, depending on how you're using them. This is a classic case of framing bias.

Two years ago if you had decided you were going to save that money in a taxable account for a home renovation, you would have sacrificed the tax-deferred 401k space and could not get it back. Putting the money into the 401k, and then taking it out as a loan now (and then paying it back in a short period of time) preserves the tax-advantaged space, wihich is better than never putting it there in the first place in anticipation of your housing goals.

Using 401k loans to pay off high-interest credit card debt is also usually a great idea. (Not having credit card debt or desires to upgrade housing would be even better, but assuming those are non-negotiable and the question is how to finance the goal, using a 401k is not the worst idea in the world.)
Actually, if they had decided two years ago that they wanted to do a renovation, they would have had another option besides not contributing to the 401k. They could have cut back the extra payments towards the school loans and quickly saved up the money for the renovation. Which was what one of the other posters suggested they do now.

This is a classic example of opportunity cost - doing one thing (e.g., paying down the school loans very aggressively) prevents you from doing something else later (e.g., home renovation) since the money is no longer available. The kicker is that at the time you did A, you may not have realized that there would be a need to do B.

rr2
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Re: is a 401k loan always terrible?

Post by rr2 » Sun Jan 15, 2017 10:01 pm

Years ago, I asked the same question and received some great advice and also learnt a lot about 401k loans and other aspects including interest, alternatives etc.

viewtopic.php?f=2&t=57638

I am grateful to forum members who posted in that thread.

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TinkerPDX
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Re: is a 401k loan always terrible?

Post by TinkerPDX » Sun Jan 15, 2017 10:32 pm

Doesn't this amount to paying someone else interes to "borrow" your own money?

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whodidntante
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Re: is a 401k loan always terrible?

Post by whodidntante » Sun Jan 15, 2017 10:44 pm

No, it's not always terrible. I took a 401k loan so I could invest my pre-tax money outside the plan.

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jimb_fromATL
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Re: is a 401k loan always terrible?

Post by jimb_fromATL » Sun Jan 15, 2017 11:05 pm

TinkerPDX wrote:Doesn't this amount to paying someone else interest to "borrow" your own money?
Not really. If you borrowed money from a bank or mortgage company or other commercial lender, you would be paying the interest to someone else. But with a 401(k) loan, you're paying the interest to yourself.

A loan -- the borrower's debt -- is the lender's investment in a lump sum annuity that has a guaranteed rate of return and guaranteed minimum periodic payment for a specific amount of time. If your funds included stock for a bank or other lending institution, that's what they would probably be doing some of with your money.

It's just that you're eliminating the middle-man by having your own 401(k) be the lender/investor and you as the borrower. It's a very secure loan, because it is required that the payments be taken out of the borrower's paycheck. (And you as the borrower don't have to qualify for the loan.)

A problem is that the way the loan rate is determined usually means that you're paying yourself an interest rate that is likely to be lower than you would be earning if the lump sum was invested in mutual funds that were earning the stock market averages. So at the end of the loan period, the 401(k) account probably won't have as much money in it. That deficit will then compound into a much bigger loss from your future retirement funds after a few decades of NOT earning compound interest.

(On the other hand, if you had a working crystal ball that could tell you that the market was going to earn less than the rate you're paying to yourself, you could come out ahead.)

jmb

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Re: is a 401k loan always terrible?

Post by Dottie57 » Sun Jan 15, 2017 11:25 pm

flybynite wrote:
Toons wrote:While we could theoretically accommodate another kid in our house as is

Do that.
Pay off all the debt.
Do not borrow from the 401k.
Save for the home improvement.
4 easy steps
:mrgreen:
In a slightly nicer tone, I agree generally with this sentiment. I have 4 kids in a 3 bedroom townhouse, the oldest of which is a junior in high school. My guess is your baby nor you will be disappointed with the extra close proximity for an extra year until you can afford the project w/o severely impacting your retirement. I would personally squash spending a bit or leverage the emergency fund slightly (and replenish the next year since you are dual income this is not as concerning as it would be for me) if I really wanted to do it a bit earlier.
I agree too. Don't borrow money from anyone or anything. In a year or two you should be able to pay in cash for your reno since you make nearly 3/4 of a million dollars a year. If you can't cash flow it then, there is something severly wrong.

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Re: is a 401k loan always terrible?

Post by ChrisC » Sun Jan 15, 2017 11:50 pm

jimb_fromATL wrote:
TinkerPDX wrote:Doesn't this amount to paying someone else interest to "borrow" your own money?

A problem is that the way the loan rate is determined usually means that you're paying yourself an interest rate that is likely to be lower than you would be earning if the lump sum was invested in mutual funds that were earning the stock market averages. So at the end of the loan period, the 401(k) account probably won't have as much money in it. That deficit will then compound into a much bigger loss from your future retirement funds after a few decades of NOT earning compound interest.

jmb
This might not be a problem at all, if the borrower has allocated 401k funds in fixed rate investments that carry the same interest rate as the interest rate of the borrowing (or loan) made from the 401k. In many cases, the 401k borrowing is at the same rate as a stable value fund option in the 401k plan; thus, if the borrower previously allocated 50K to a stable value option in his 401k plan and is able to borrow 50K from his stable option allocation, then there shouldn't be any effect on earnings growth in the 401k from this borrowing. Also, if the borrower is 100 percent in equities in his 401k, and wishes to allocate 50k to his fixed rate option in his plan, then the borrowing of 50k would facilitate this allocation without any reduced expectations in earnings growth in the plan.

I've borrowed several times from my 401k while employed (and though it's not something I would recommend to others), in some cases this was simply too good of a deal for me to pass up given my financial needs at the time. I'll admit, however, that on one occasion, the borrowing amounted to taking a cash position in the 401k, as the interest rate on the borrowing was .14 percent for 50K -- at that time, my plan had an interest rate on borrowing much lower than the rate for the stable value fixed income option in my plan -- the administrator and employer-employee 401k management committee later changed this and made interest rates on borrowings equal to fixed income rate options available in the plan.

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Re: is a 401k loan always terrible?

Post by jimb_fromATL » Mon Jan 16, 2017 12:08 am

ChrisC wrote:
jimb_fromATL wrote:
TinkerPDX wrote:Doesn't this amount to paying someone else interest to "borrow" your own money?

A problem is that the way the loan rate is determined usually means that you're paying yourself an interest rate that is likely to be lower than you would be earning if the lump sum was invested in mutual funds that were earning the stock market averages. So at the end of the loan period, the 401(k) account probably won't have as much money in it. That deficit will then compound into a much bigger loss from your future retirement funds after a few decades of NOT earning compound interest.

jmb
This might not be a problem at all, if the borrower has allocated 401k funds in fixed rate investments that carry the same interest rate as the interest rate of the borrowing (or loan) made from the 401k. In many cases, the 401k borrowing is at the same rate as a stable value fund option in the 401k plan; thus, if the borrower previously allocated 50K to a stable value option in his 401k plan and is able to borrow 50K from his stable option allocation, then there shouldn't be any effect on earnings growth in the 401k from this borrowing. Also, if the borrower is 100 percent in equities in his 401k, and wishes to allocate 50k to his fixed rate option in his plan, then the borrowing of 50k would facilitate this allocation without any reduced expectations in earnings growth in the plan.

I've borrowed several times from my 401k while employed (and though it's not something I would recommend to others), in some cases this was simply too good of a deal for me to pass up given my financial needs at the time. I'll admit, however, that on one occasion, the borrowing amounted to taking a cash position in the 401k, as the interest rate on the borrowing was .14 percent for 50K -- at that time, my plan had an interest rate on borrowing much lower than the rate for the stable value fixed income option in my plan -- the administrator and employer-employee 401k management committee later changed this and made interest rates on borrowings equal to fixed income rate options available in the plan.
According to a lot of sources I've read and a number of discussions of actual loans over a number of years, a lot of 401(k) plans require that the money for the loan is provided by selling off your funds in proportion to your fund allocations, and that payments be put back in the same proportions as your contributions are allocated.

So a lot of folks cannot choose to treat the 401(k) loan as merely a low-return guaranteed/stable value portion of their investment. In that case, they'd be taking money out of their higher-earning funds and are putting it back into those funds at a lower rate than the best balance of funds would be earning in a normal market.

jimb

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wander
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Re: is a 401k loan always terrible?

Post by wander » Mon Jan 16, 2017 12:19 am

I borrowed money from my 401k. The paid back money was removed from my paycheck directly and I was still able to continue maxing my 401k. I will do it again.

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Re: is a 401k loan always terrible?

Post by Ketawa » Mon Jan 16, 2017 12:21 am

jimb_fromATL wrote:
ChrisC wrote:This might not be a problem at all, if the borrower has allocated 401k funds in fixed rate investments that carry the same interest rate as the interest rate of the borrowing (or loan) made from the 401k. In many cases, the 401k borrowing is at the same rate as a stable value fund option in the 401k plan; thus, if the borrower previously allocated 50K to a stable value option in his 401k plan and is able to borrow 50K from his stable option allocation, then there shouldn't be any effect on earnings growth in the 401k from this borrowing. Also, if the borrower is 100 percent in equities in his 401k, and wishes to allocate 50k to his fixed rate option in his plan, then the borrowing of 50k would facilitate this allocation without any reduced expectations in earnings growth in the plan.

I've borrowed several times from my 401k while employed (and though it's not something I would recommend to others), in some cases this was simply too good of a deal for me to pass up given my financial needs at the time. I'll admit, however, that on one occasion, the borrowing amounted to taking a cash position in the 401k, as the interest rate on the borrowing was .14 percent for 50K -- at that time, my plan had an interest rate on borrowing much lower than the rate for the stable value fixed income option in my plan -- the administrator and employer-employee 401k management committee later changed this and made interest rates on borrowings equal to fixed income rate options available in the plan.
According to a lot of sources I've read and a number of discussions of actual loans over a number of years, a lot of 401(k) plans require that the money for the loan is provided by selling off your funds in proportion to your fund allocations, and that payments be put back in the same proportions as your contributions are allocated.

So a lot of folks cannot choose to treat the 401(k) loan as merely a low-return guaranteed/stable value portion of their investment. In that case, they'd be taking money out of their higher-earning funds and are putting it back into those funds at a lower rate than the best balance of funds would be earning in a normal market.

jimb
The investor can always choose to change the 401k's asset allocation or contribution allocations.

You are no longer performing an apples to apples comparison when considering investing in higher expected return equities vs fixed income. This type of analysis should always be done by considering the fixed income options available to the investor and not equities, and for good reason. The investor can typically choose to sell fixed income and buy equities if they want more funds in risky asset classes. This is all spelled out in great detail in the Paying down loans versus investing wiki article.

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wander
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Re: is a 401k loan always terrible?

Post by wander » Mon Jan 16, 2017 12:39 am

jimb_fromATL wrote: According to a lot of sources I've read and a number of discussions of actual loans over a number of years, a lot of 401(k) plans require that the money for the loan is provided by selling off your funds in proportion to your fund allocations, and that payments be put back in the same proportions as your contributions are allocated.

So a lot of folks cannot choose to treat the 401(k) loan as merely a low-return guaranteed/stable value portion of their investment. In that case, they'd be taking money out of their higher-earning funds and are putting it back into those funds at a lower rate than the best balance of funds would be earning in a normal market.

jimb
When I borrowed the money, the asset allocation of my 401k was messed up a little. But I adjusted my asset allocation next day and treated the payments as new money.

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Re: is a 401k loan always terrible?

Post by VaR » Mon Jan 16, 2017 12:56 am

In some ways, I see getting a 401k loan as equivalent to using emergency funds, just with different consequences. This is because there are certain emergencies - job loss, for example, that would require immediately paying off the 401k loan from the emergency fund.

Anyway, I see nothing particularly dangerous about tapping a 401k loan for this liquidity crisis. OTOH, don't make this a habit.

I also suggest being extra frugal for the next year in order to pay off the loan as quickly as possible. Even if you can't pay it off faster, you should overfund your emergency fund to the amount of your 401k loan in case the "emergency" of having to pay back the 401k loan comes up.

Are you sure you can't get a HELOC to cover the renovation?

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Re: is a 401k loan always terrible?

Post by ChrisC » Mon Jan 16, 2017 1:43 am

Ketawa wrote:
jimb_fromATL wrote:
ChrisC wrote:This might not be a problem at all, if the borrower has allocated 401k funds in fixed rate investments that carry the same interest rate as the interest rate of the borrowing (or loan) made from the 401k. In many cases, the 401k borrowing is at the same rate as a stable value fund option in the 401k plan; thus, if the borrower previously allocated 50K to a stable value option in his 401k plan and is able to borrow 50K from his stable option allocation, then there shouldn't be any effect on earnings growth in the 401k from this borrowing. Also, if the borrower is 100 percent in equities in his 401k, and wishes to allocate 50k to his fixed rate option in his plan, then the borrowing of 50k would facilitate this allocation without any reduced expectations in earnings growth in the plan.

I've borrowed several times from my 401k while employed (and though it's not something I would recommend to others), in some cases this was simply too good of a deal for me to pass up given my financial needs at the time. I'll admit, however, that on one occasion, the borrowing amounted to taking a cash position in the 401k, as the interest rate on the borrowing was .14 percent for 50K -- at that time, my plan had an interest rate on borrowing much lower than the rate for the stable value fixed income option in my plan -- the administrator and employer-employee 401k management committee later changed this and made interest rates on borrowings equal to fixed income rate options available in the plan.
According to a lot of sources I've read and a number of discussions of actual loans over a number of years, a lot of 401(k) plans require that the money for the loan is provided by selling off your funds in proportion to your fund allocations, and that payments be put back in the same proportions as your contributions are allocated.

So a lot of folks cannot choose to treat the 401(k) loan as merely a low-return guaranteed/stable value portion of their investment. In that case, they'd be taking money out of their higher-earning funds and are putting it back into those funds at a lower rate than the best balance of funds would be earning in a normal market.

jimb
The investor can always choose to change the 401k's asset allocation or contribution allocations.

You are no longer performing an apples to apples comparison when considering investing in higher expected return equities vs fixed income. This type of analysis should always be done by considering the fixed income options available to the investor and not equities, and for good reason. The investor can typically choose to sell fixed income and buy equities if they want more funds in risky asset classes. This is all spelled out in great detail in the Paying down loans versus investing wiki article.
This. Even in plans which proportionately take out borrowed funds from different fund allocations, this is an easy work-around.

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Re: is a 401k loan always terrible?

Post by sunny_socal » Mon Jan 16, 2017 2:14 am

Borrow it, not a big deal. Just be sure to pay it back.

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Re: is a 401k loan always terrible?

Post by dm200 » Mon Jan 16, 2017 9:23 am

My logic/calculations are somewhat simpler to reach my conclusion that a 401k loan is usually [BUT NOT ALWAYS] a bad idea:

1. I assume that the 401k investments are structured for the long term and that the expected return is, therefore, relatively high.

2. So, for example, we might expect an annual return of, say, 6-10% per year. Let's say 7%

3. The balace on which you might expect 7% goes down by the amount of the loan.

4. You are losing the opportunity to earn, say, 7% on this money.

5. Yes, you pay back the amount of the "loan" plus more for interest, but you have a net "loss" (opportunity cost).

6. There are, not trivial, fees normally charged for taking out such a loan.

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Re: is a 401k loan always terrible?

Post by flybynite » Mon Jan 16, 2017 9:37 am

Dottie57 wrote:
flybynite wrote:
Toons wrote:While we could theoretically accommodate another kid in our house as is

Do that.
Pay off all the debt.
Do not borrow from the 401k.
Save for the home improvement.
4 easy steps
:mrgreen:
In a slightly nicer tone, I agree generally with this sentiment. I have 4 kids in a 3 bedroom townhouse, the oldest of which is a junior in high school. My guess is your baby nor you will be disappointed with the extra close proximity for an extra year until you can afford the project w/o severely impacting your retirement. I would personally squash spending a bit or leverage the emergency fund slightly (and replenish the next year since you are dual income this is not as concerning as it would be for me) if I really wanted to do it a bit earlier.
I agree too. Don't borrow money from anyone or anything. In a year or two you should be able to pay in cash for your reno since you make nearly 3/4 of a million dollars a year. If you can't cash flow it then, there is something severly wrong.
One often missed item in these threads is psychological factors in the decisions, and the impact on your future behavior. Just above this thread is a lot of people encouraging the OP to just take the money (primarily people who have done it themselves), there is no harm (this is also a psychological trait, they are wanting you to affirm their previous decision). In fact, any time you take on debt (even to yourself), you should think very carefully as it's a long term commitment that you must fulfill versus using cash flow to meet your needs as they come up. Several mention they have done it successfully several times (proving the point if you do it once, you are probably more likely to do it again). Have no doubt OP, if you take money for a home renovation just this once because it feels "urgent" at the moment, you are likely to do it again in the future. Each time you are reducing by a large amount your total investment return as you money will not be in the market. Also, something equally or even more urgent than adding an extra room to the house is likely to come up in the future.

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Re: is a 401k loan always terrible?

Post by ERISA Stone » Mon Jan 16, 2017 10:52 am

cherijoh wrote:
Caduceus wrote:401k loans are perfectly fine, depending on how you're using them. This is a classic case of framing bias.

Two years ago if you had decided you were going to save that money in a taxable account for a home renovation, you would have sacrificed the tax-deferred 401k space and could not get it back. Putting the money into the 401k, and then taking it out as a loan now (and then paying it back in a short period of time) preserves the tax-advantaged space, wihich is better than never putting it there in the first place in anticipation of your housing goals.

Using 401k loans to pay off high-interest credit card debt is also usually a great idea. (Not having credit card debt or desires to upgrade housing would be even better, but assuming those are non-negotiable and the question is how to finance the goal, using a 401k is not the worst idea in the world.)
Actually, if they had decided two years ago that they wanted to do a renovation, they would have had another option besides not contributing to the 401k. They could have cut back the extra payments towards the school loans and quickly saved up the money for the renovation. Which was what one of the other posters suggested they do now.

This is a classic example of opportunity cost - doing one thing (e.g., paying down the school loans very aggressively) prevents you from doing something else later (e.g., home renovation) since the money is no longer available. The kicker is that at the time you did A, you may not have realized that there would be a need to do B.
Except that they didn't decide to do a renovation two years ago. They are considering it now. It's odd to criticize the OP for paying down loans aggressively, especially on this site.

I agree with others that it might be better in this scenario to scale back paying off some of your other debt rather than taking a 401k loan here. However, I don't have any issue with borrowing from your 401k plan as long as you understand the risks, the primary one being you may be on the hook for a large payoff in the event you terminate employment. Some plans do allow you to continue paying after termination and others allow you to roll loans into their plans. However, these are extremely rare due to the risk it creates for both parties.

Congrats on paying your debts off so quickly. That note seems to be getting lost here by some posters.

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Re: is a 401k loan always terrible?

Post by flybynite » Mon Jan 16, 2017 11:22 am

ERISA Stone wrote:
cherijoh wrote:
Caduceus wrote:401k loans are perfectly fine, depending on how you're using them. This is a classic case of framing bias.

Two years ago if you had decided you were going to save that money in a taxable account for a home renovation, you would have sacrificed the tax-deferred 401k space and could not get it back. Putting the money into the 401k, and then taking it out as a loan now (and then paying it back in a short period of time) preserves the tax-advantaged space, wihich is better than never putting it there in the first place in anticipation of your housing goals.

Using 401k loans to pay off high-interest credit card debt is also usually a great idea. (Not having credit card debt or desires to upgrade housing would be even better, but assuming those are non-negotiable and the question is how to finance the goal, using a 401k is not the worst idea in the world.)
Actually, if they had decided two years ago that they wanted to do a renovation, they would have had another option besides not contributing to the 401k. They could have cut back the extra payments towards the school loans and quickly saved up the money for the renovation. Which was what one of the other posters suggested they do now.

This is a classic example of opportunity cost - doing one thing (e.g., paying down the school loans very aggressively) prevents you from doing something else later (e.g., home renovation) since the money is no longer available. The kicker is that at the time you did A, you may not have realized that there would be a need to do B.
Except that they didn't decide to do a renovation two years ago. They are considering it now. It's odd to criticize the OP for paying down loans aggressively, especially on this site.

I agree with others that it might be better in this scenario to scale back paying off some of your other debt rather than taking a 401k loan here. However, I don't have any issue with borrowing from your 401k plan as long as you understand the risks, the primary one being you may be on the hook for a large payoff in the event you terminate employment. Some plans do allow you to continue paying after termination and others allow you to roll loans into their plans. However, these are extremely rare due to the risk it creates for both parties.

Congrats on paying your debts off so quickly. That note seems to be getting lost here by some posters.
Actually, the poster you just responded to acknowledged that the B (home renovation) may not have been realizable when doing A (paying down loans) and I don't believe was disparaging in anyway. I also congratulate the OP for paying off his debts so quickly, I encourage him to continue that track record by not taking out a large amount of new debt. I agree lack of job is a huge risk of this type of loan, the other being opportunity cost on the returns, which is much more likely, as well as encouraging future thoughts that debt is a good mechanism of funding purchases. The OP has acknowledged that the child will fit in their existing house, an interesting question is why not wait until money is saved for this home renovation then. This has a lot of advantages as you have the knowledge upon spending the saved money that nothing else is now more important than the renovation at that future time (~2 years) including no job losses were incurred over the period of savings that would change your decision.

Upon rereading, another piece of information here that is missing is what percentage of this retirement savings does the proposed loan amount to.

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Re: is a 401k loan always terrible?

Post by WhiteMaxima » Mon Jan 16, 2017 11:48 am

A 401k loan is not a bad loan option for short period of time. For example, during the 2009 housing bubble burst, I borrowed 50k from 401k and bought my ideal house at 20% discount. Because I need to put 20% down but I was just short. The the following months, I repayed my loan quickly to recapture the stock market recovery. Another example, if you think the stock market is overvalued, the borrow from 401k at 3% the interest rate to pay down your higher interest loan. If market correct for -10%. You basically locked your gain before the correction and make some saving on interest difference. The interest you pay to your 401k is yours. So many situation makes 401k loan a vaild option.

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Re: is a 401k loan always terrible?

Post by jimb_fromATL » Mon Jan 16, 2017 11:59 am

ChrisC wrote:
Ketawa wrote:
jimb_fromATL wrote:
ChrisC wrote:This might not be a problem at all, if the borrower has allocated 401k funds in fixed rate investments that carry the same interest rate as the interest rate of the borrowing (or loan) made from the 401k. In many cases, the 401k borrowing is at the same rate as a stable value fund option in the 401k plan; thus, if the borrower previously allocated 50K to a stable value option in his 401k plan and is able to borrow 50K from his stable option allocation, then there shouldn't be any effect on earnings growth in the 401k from this borrowing. Also, if the borrower is 100 percent in equities in his 401k, and wishes to allocate 50k to his fixed rate option in his plan, then the borrowing of 50k would facilitate this allocation without any reduced expectations in earnings growth in the plan.

I've borrowed several times from my 401k while employed (and though it's not something I would recommend to others), in some cases this was simply too good of a deal for me to pass up given my financial needs at the time. I'll admit, however, that on one occasion, the borrowing amounted to taking a cash position in the 401k, as the interest rate on the borrowing was .14 percent for 50K -- at that time, my plan had an interest rate on borrowing much lower than the rate for the stable value fixed income option in my plan -- the administrator and employer-employee 401k management committee later changed this and made interest rates on borrowings equal to fixed income rate options available in the plan.
According to a lot of sources I've read and a number of discussions of actual loans over a number of years, a lot of 401(k) plans require that the money for the loan is provided by selling off your funds in proportion to your fund allocations, and that payments be put back in the same proportions as your contributions are allocated.

So a lot of folks cannot choose to treat the 401(k) loan as merely a low-return guaranteed/stable value portion of their investment. In that case, they'd be taking money out of their higher-earning funds and are putting it back into those funds at a lower rate than the best balance of funds would be earning in a normal market.

jimb
The investor can always choose to change the 401k's asset allocation or contribution allocations.

You are no longer performing an apples to apples comparison when considering investing in higher expected return equities vs fixed income. This type of analysis should always be done by considering the fixed income options available to the investor and not equities, and for good reason. The investor can typically choose to sell fixed income and buy equities if they want more funds in risky asset classes. This is all spelled out in great detail in the Paying down loans versus investing wiki article.
This. Even in plans which proportionately take out borrowed funds from different fund allocations, this is an easy work-around.
Not the same thing and not necessarily an easy work-around within the 401(k). The wiki is about choosing how to reallocate NEW contributions to investments, and considering paying off a loan as an investment -- which it is, since the net result is the same.

But a 401(k) loan is not investing new money. It is only putting back money that you took out of existing funds.

Normally you cannot just take the money out of your stable value funds in the 401(k) and put it back in that category alone. With most 401(k)s the money for the loan is taken out in proportion from all of your funds categories. And it is returned in proportion to your fund allocations. So the 401(k) payments are returning the money to the higher-earning funds with a lower earnings rate than they would normally be expected to earn.

Essentially the only way you can win with a 401(k) loan is to know in advance that you are going to lose by having your total 401(k) funds earn less than the rate you're paying out of pocket on the loan while you're replenishing the money you took out.

So ... what are your chances that a typical balance of investment funds in your 401(k) will do worse than your 401(k) loan rate for the max of 5 years? Not great -- fortunately for your 401(k) funds, but unfortunately if you take out a loan from it.

Vanguard’s balanced fund VWELX is usually about 65%/35% stocks versus stable value like bonds and notes. Plus it does as well or better than the majority of portfolios I've seen proposed and discussed on talk forums, newsletters, websites, and magazines. So IMO it’s a reasonable comparison:
  • Since 01/1980 the average APY for 384 rolling 60 month periods for DCA monthly contributions to VWELX has been 10.12%. The worst was -7.58% for the 60 month period ending the week of 02/02/2009. The best was 19.42% ending the week of 06/02/1986. Overall, 89% of the periods did as well or better than 4.75%.

    Incidentally, for more aggressive investing, such as all stocks in the S&P 500: Since 01/1980 the average APY for 384 rolling 60 month periods for DCA monthly contributions to VFINX has been 9.98%. The worst was -20.09% for the 60 month period ending the week of 02/02/2009. The best was 25.86% ending the week of 01/04/1999. Still, 78% of the periods did as well or better than 4.75%.

Here are some links and excerpts of numerous descriptions of how the funds are usually allocated for 401(k) loans. As I mentioned earlier, I know of a lot of real-life instances from forum discussions and other correspondence over a long time where this is indeed the way it worked.
  • https://401k.guardianlife.com/Participa ... HyPHmczVjo
    • Here's how a 401(k) loan works. Your plan sponsor (your employer) sells a portion of the plan investments from your account equal in value to the loan amount. For instance, if your account is invested 70% in a stock fund and 30% in a bond fund, the assets will be sold in the same proportions. The loan payments you make will be reinvested in whatever your then-current allocations are.
    https://www.401kcenter.info/acropolis_l ... -loans.php
    • Here’s how a 401(k) loan works: The 401(k) sponsor (your employer) sells a portion of the plan investments from your account equal in value to the loan amount. If your 401(k) account is invested 70% in a stock mutual fund and 30% in a fixed-income mutual fund, the assets will be sold in the same proportions. The loan payments you make will be reinvested in whatever your then-current allocations are.
    https://www.smart401k.com/resource-cent ... plan-loans
    • ”…In most cases plans will sell off funds proportionally to keep percentage allocations the same.

      When you sell off shares to fund a loan, the market could be lower than it will be as you repay the loan…”
jimb
Last edited by jimb_fromATL on Mon Jan 16, 2017 12:18 pm, edited 1 time in total.

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Re: is a 401k loan always terrible?

Post by jane1 » Mon Jan 16, 2017 12:17 pm

If the entire (or most) 401k is in the bond (fixed income) portion of your asset allocation (which is recommended for tax-efficient placement), wouldn't paying yourself 4-5% be not too bad? More so, when you are reasonably confident that you can pay "loan" back. I understand things can go wrong. I haven't given it much thought but could that be a way to shift some $ from taxable account into a 401k?

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Re: is a 401k loan always terrible?

Post by jimb_fromATL » Mon Jan 16, 2017 12:24 pm

jane1 wrote:If the entire (or most) 401k is in the bond (fixed income) portion of your asset allocation (which is recommended for tax-efficient placement), wouldn't paying yourself 4-5% be not too bad? More so, when you are reasonably confident that you can pay "loan" back. I understand things can go wrong. I haven't given it much thought but could that be a way to shift some $ from taxable account into a 401k?
If your entire 401(k) were invested in funds that are expected to earn less than the 401(k) loan rate, then a 401(k) loan could actually be a good way to put more money out-of-pocket into the account where it could then earn compound interest with taxes on dividends and interest deferred. The same would apply if your crystal ball could tell you when the market is going to be bad for the entire length of the loan.

It would take some heavy math to guess whether paying regular income taxes on all the withdrawals in retirement would be better than paying cap gains tax from year to year on dividends, then the (usually) lower cap gains tax rate on the gain in value later.

However, I've never heard of anybody suggesting to guarantee getting nothing but low returns in a 401(k) by investing only in low-return fixed income funds. The main reason for investing is in the hope that the stock market will continue to do as it has done for its entire history, and return more than the inflation rate ... which you are not nearly as likely to be able to do in stable value funds.

jimb

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Re: is a 401k loan always terrible?

Post by straws46 » Mon Jan 16, 2017 12:31 pm

Not sure of this, but doesn't a loan eliminate the primary benefit of the 401k ... tax deferment? Don't you repay the loan with after-tax dollars and then still have to pay taxes when it gets distributed?

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Re: is a 401k loan always terrible?

Post by jimb_fromATL » Mon Jan 16, 2017 12:56 pm

straws46 wrote:Not sure of this, but doesn't a loan eliminate the primary benefit of the 401k ... tax deferment? Don't you repay the loan with after-tax dollars and then still have to pay taxes when it gets distributed?
No, but that's a misunderstanding that you can find on a lot of websites and hear on talk shows and read in books and magazines and newsletters.

Assuming a tax-deferred account, you don't pay any tax on the money you put into your 401(k) until you withdraw it. You only pay taxes on what you withdraw after retirement.

You would be paying taxes on the income used to pay back a loan to a commercial lender anyway, so it really makes no difference whether you're paying the after-tax money to some other lender or to your own 401(k) loan.

Here's another way to look at it.

When your money is invested within your 401(k), you're buying stock in some entity that will use your money (in stocks, money market accounts, bonds, CDs, etc). In exchange, they will pay you interest or dividends, and you'll hopefully get additional gains in value of the stock over the long run.

If your 401(k) funds own stock in a bank, the money a borrower pays in taxes on the income they used to pay back their bank loan is not relevant to how much interest the bank earns on the loan, or how much tax the bank pays on corporate earnings, or to how much you earn on the stock. The same principle applies with a 401(k) loan where your account is the lender and you are the borrower.

In fact, because you're usually paying yourself back at a lower than market rate, it will take less of your pre-tax money --and you will pay less total income tax-- in order to pay back the 401(k) loan than it would take out of your pay to make the payments on a higher rate commercial loan.

The problem is that because people usually pay back a lower rate of interest to their 401(k) than the lump sum would be expected to earn during that time period, they will usually end up with less money in the 401(k) account at retirement time. So... you'll probably actually pay even less tax when you withdraw it ... but part of it is because you won't have as much money to withdraw. :(

jimb

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Re: is a 401k loan always terrible?

Post by curmudgeon » Mon Jan 16, 2017 1:53 pm

I'm not sure i would worry that much about the specific source of the money given your cash flows. You are talking a few hundred dollars either way. Personally, I'd probably delay paying off the last student loan, and pay for the renovation from a combination of cash flow and emergency fund (I wouldn't be afraid to treat credit cards as the backup emergency fund for a few months). Doing a short-term 401k loan is being a bit more conservative (though if this was 2008, I wouldn't want to be doing this). If the renovation was $250K, I might look at it differently.

I would be more focused on the challenges of managing the renovation itself. 1) making sure that it didn't go way over budget (pretty easy in a VHCOL area). 2) making sure that the disruption while it is happening doesn't drive you crazy - stuff often takes much longer than planned, and new paint/carpet smells, dust, etc can really interfere with your life.

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Re: is a 401k loan always terrible?

Post by stlutz » Mon Jan 16, 2017 2:04 pm

Is a $75K renovation truly going to be done when the second child arrives? How far are you into the process of selecting a contractor, deciding what you want etc.?

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Re: is a 401k loan always terrible?

Post by jane1 » Mon Jan 16, 2017 2:42 pm

jimb_fromATL wrote: However, I've never heard of anybody suggesting to guarantee getting nothing but low returns in a 401(k) by investing only in low-return fixed income funds. The main reason for investing is in the hope that the stock market will continue to do as it has done for its entire history, and return more than the inflation rate ... which you are not nearly as likely to be able to do in stable value funds.

jimb
If one's US stocks are in Roth & taxable, intl stocks are in taxable and bonds are in 401k as suggested in
https://www.bogleheads.org/wiki/Tax-eff ... _placement
couldn't one end up with a good part of 401k in bonds? Or even all (based on fraction of assets within each type). Not ideal to have low-return fixed income funds, but if you want to maintain your AA, you have to put bonds/CDs somewhere. Or am interpreting placement of funds wiki incorrectly?

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Re: is a 401k loan always terrible?

Post by jimb_fromATL » Mon Jan 16, 2017 3:12 pm

jane1 wrote:
jimb_fromATL wrote: However, I've never heard of anybody suggesting to guarantee getting nothing but low returns in a 401(k) by investing only in low-return fixed income funds. The main reason for investing is in the hope that the stock market will continue to do as it has done for its entire history, and return more than the inflation rate ... which you are not nearly as likely to be able to do in stable value funds.

jimb
If one's US stocks are in Roth & taxable, intl stocks are in taxable and bonds are in 401k as suggested in
https://www.bogleheads.org/wiki/Tax-eff ... _placement
couldn't one end up with a good part of 401k in bonds? Or even all (based on fraction of assets within each type). Not ideal to have low-return fixed income funds, but if you want to maintain your AA, you have to put bonds/CDs somewhere. Or am interpreting placement of funds wiki incorrectly?
I think you may be misinterpreting it.

It says:
If your investments are all in tax-advantaged accounts, fund placement will not have a large impact on your returns.
... and
If you have both tax-advantaged (retirement) and taxable accounts, you generally want to hold less tax-efficient assets in a tax-advantaged account and more tax-efficient assets in a taxable account
Seems to me that supports putting your funds that have the highest potential for earnings and gain in value in your 401(k) -- which would be stocks in mutual funds ... if history is any indicator at all. The more they’re paying in dividends or interest and gaining in values the more taxes you would pay from year to year in a taxable account – instead of deferring all the taxes until retirement time in a 401(k) or other tax-advantaged account.

jimb

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Re: is a 401k loan always terrible?

Post by dm200 » Mon Jan 16, 2017 4:12 pm

straws46 wrote:Not sure of this, but doesn't a loan eliminate the primary benefit of the 401k ... tax deferment? Don't you repay the loan with after-tax dollars and then still have to pay taxes when it gets distributed?
Even though I do think a 401k "loan" is usually not a good idea, I do not think this "after tax dollars" repayment is valid. When you take the money out of the 401k from a "loan", there is no tax obligation due or paid, so that when you repay the money back into the 401k you are, for most part at least, just putting back the money that was taken out. Perhaps this argument may be valid for the small amount of interest that you pay back to the 401k on the loan.

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Re: is a 401k loan always terrible?

Post by emoore » Mon Jan 16, 2017 4:41 pm

dm200 wrote:
straws46 wrote:Not sure of this, but doesn't a loan eliminate the primary benefit of the 401k ... tax deferment? Don't you repay the loan with after-tax dollars and then still have to pay taxes when it gets distributed?
Even though I do think a 401k "loan" is usually not a good idea, I do not think this "after tax dollars" repayment is valid. When you take the money out of the 401k from a "loan", there is no tax obligation due or paid, so that when you repay the money back into the 401k you are, for most part at least, just putting back the money that was taken out. Perhaps this argument may be valid for the small amount of interest that you pay back to the 401k on the loan.
+1

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Re: is a 401k loan always terrible?

Post by Earl Lemongrab » Mon Jan 16, 2017 4:56 pm

jimb_fromATL wrote:Normally you cannot just take the money out of your stable value funds in the 401(k) and put it back in that category alone. With most 401(k)s the money for the loan is taken out in proportion from all of your funds categories. And it is returned in proportion to your fund allocations. So the 401(k) payments are returning the money to the higher-earning funds with a lower earnings rate than they would normally be expected to earn.
I don't think you're understanding what people are saying. Many plans allow reallocating quickly and easily. So if you had half in bonds and half in stocks, and you wanted the loan to come out of bonds only, you'd just move the requisite amount from bonds to stocks afterwards. Similarly on payback (although that's a much more gradual process) you'd just reallocate as needed to keep the proportion of bonds and stocks that you want.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

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Re: is a 401k loan always terrible?

Post by Dottie57 » Mon Jan 16, 2017 8:21 pm

OP: I just picked a copy of "The Millionaire Next Door". Pretty eye opening. Pick up a copy ( paper back) and give it a read. Very readable and entertaining.

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