Using 401k Loans to increase contribution

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
DaniaBeachGuy
Posts: 4
Joined: Wed May 15, 2019 7:55 am

Using 401k Loans to increase contribution

Post by DaniaBeachGuy » Wed May 15, 2019 8:00 am

New user here. Very much looking forward to learning & contributing.

A quick question: what's the general feeling about using 401k loans as a means to increase one's yearly contribution into their 401k. I'm maxing out my annual contributions, but have ability to contribute slightly more. The thought occurred to me to take out the max 50k; and in very short time frame (week, month, more?) pay back the principle along with the "interest" (at current rate, it'd be about 8k). It occurred to me that if one could do this annually, it'd be a way to supercharge the growth. Is there any rule preventing one from doing this?

Thank you in advance for your comments & suggestions.

BuckyBadger
Posts: 906
Joined: Tue Nov 01, 2011 11:28 am

Re: Using 401k Loans to increase contribution

Post by BuckyBadger » Wed May 15, 2019 9:09 am

Can you really repay the entirety of the interest without having the loan for the entirety of the time?

rai
Posts: 1180
Joined: Tue Apr 06, 2010 7:11 am

Re: Using 401k Loans to increase contribution

Post by rai » Wed May 15, 2019 9:24 am

Sounds like a bad idea.
"Life is what happens to you while you're busy making other plans" - John Lennon. | | "You say that money, isn't everything | But I'd like to see you live without it." - Silverchair

Grogs
Posts: 490
Joined: Tue Mar 24, 2015 4:55 pm

Re: Using 401k Loans to increase contribution

Post by Grogs » Wed May 15, 2019 9:56 am

Wouldn't you only be charged interest for the month or whatever until you paid off the loan? One month at 4% interest is only $167 on $50k, which doesn't seem like the effort.

lakpr
Posts: 1433
Joined: Fri Mar 18, 2011 9:59 am

Re: Using 401k Loans to increase contribution

Post by lakpr » Wed May 15, 2019 10:00 am

Even if the plan works, you are essentially repaying pre-tax dollars with post-tax dollars that will be taxed again in the future when you withdraw. Essentially that means you are losing an amount equal to your marginal tax rate (don’t forget to include state taxes too) on every dollar you repay to the plan. This is why 401k loans are a very bad idea.

Why not investigate if your plan allows after-tax contributions to the plan, which you can then convert into Roth 401k within the plan or transfer it out to an external Roth IRA? (Mega Back Door Roth, read the wiki entry)

Filetmerlot
Posts: 30
Joined: Mon Jul 09, 2018 3:15 pm

Re: Using 401k Loans to increase contribution

Post by Filetmerlot » Wed May 15, 2019 10:03 am

I don't see the point. How are you supercharging growth by taking out a loan and then paying it back right away with interest, and how is the interest in a week or a month going to be 8k on a 50k loan? Am I missing something?

Topic Author
DaniaBeachGuy
Posts: 4
Joined: Wed May 15, 2019 7:55 am

Re: Using 401k Loans to increase contribution

Post by DaniaBeachGuy » Wed May 15, 2019 10:16 am

Let me clarify what I meant...

1. take out a $50,000 loan from 401; claim term of 60 months
2. @ 6.5% "interest" (which you pay to yourself); total interest charge is $8,626.06
3. funds dispersed
4. first deduction from paycheck = 450.98
5. as per Fidelity, "Note that you cannot make a prepayment until after your first regular payment has occurred"
6. assuming you can prepay the full amount back almost immediately after 1st payment, you pay rest of whatever's left from 50,000 principle and 8k in interest charges
7. you're now up 8k over & above where you started....only thing you've "lost" is whatever gains *might* have occurred in the month since you withdrew funds
8. higher balance continues compound...

I'm failing to see the downside. Only big question in my mind is what the minimum amount of time that you need to hold the withdrawn funds outside of your account before you can prepay in full.

Thoughts?

User avatar
David Jay
Posts: 6505
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Using 401k Loans to increase contribution

Post by David Jay » Wed May 15, 2019 10:31 am

Our 401K supplier also used the term “pay interest to yourself” when describing the 401K loan process. That is theoretically true but not operationally true. Typically the collateral must be placed in the most conservative treasury or stable value fund, where it can’t participate in stock market levels of return.

You do not pay yourself $8000 in interest the first month, you pay that over the life of the loan if it runs the full 60 months. You want to pay it off after 1 month, so you will “pay yourself” about $270 (depending on interest rate), not $8000.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

Topic Author
DaniaBeachGuy
Posts: 4
Joined: Wed May 15, 2019 7:55 am

Re: Using 401k Loans to increase contribution

Post by DaniaBeachGuy » Wed May 15, 2019 10:42 am

ah, ok, thank you. thought the "interest" portion of that was a fixed value.

bberris
Posts: 1186
Joined: Sun Feb 20, 2011 9:44 am

Re: Using 401k Loans to increase contribution

Post by bberris » Wed May 15, 2019 6:52 pm

A 401k loan does not leverage your investments. Is that what you meant by "supercharge"?
The loan is actually a withdrawal and is funded by selling your assets. So you would be taking a withdrawal to make a contribution.
The only situation where this might be useful is if you expect a windfall for next year and you couldn't afford to make the maximum contribution this year.

MotoTrojan
Posts: 4189
Joined: Wed Feb 01, 2017 8:39 pm

Re: Using 401k Loans to increase contribution

Post by MotoTrojan » Wed May 15, 2019 6:56 pm

DaniaBeachGuy wrote:
Wed May 15, 2019 10:16 am
Let me clarify what I meant...

1. take out a $50,000 loan from 401; claim term of 60 months
2. @ 6.5% "interest" (which you pay to yourself); total interest charge is $8,626.06
3. funds dispersed
4. first deduction from paycheck = 450.98
5. as per Fidelity, "Note that you cannot make a prepayment until after your first regular payment has occurred"
6. assuming you can prepay the full amount back almost immediately after 1st payment, you pay rest of whatever's left from 50,000 principle and 8k in interest charges
7. you're now up 8k over & above where you started....only thing you've "lost" is whatever gains *might* have occurred in the month since you withdrew funds
8. higher balance continues compound...

I'm failing to see the downside. Only big question in my mind is what the minimum amount of time that you need to hold the withdrawn funds outside of your account before you can prepay in full.

Thoughts?
The $8K in interest you paid is not deductible though, is it (above post suggests not)? So you are getting taxed twice on those dollars after withdrawal; you would've been better off using a taxable account with a tax-efficient equity fund if my understanding is correct.

Also I have never heard of a loan that sets the total interest and then still requires that even if you prepay. Your prepay will result in far less interest being due.

lkar
Posts: 60
Joined: Sat May 04, 2019 4:02 pm

Re: Using 401k Loans to increase contribution

Post by lkar » Wed May 15, 2019 7:03 pm

What about this though? Let's say that you are eligible to contribute after-tax dollars to your employer's 401k but don't have the funds to do so?

You borrow $20,000 from a 40lk, then contribute those $20,000 into the same fund as aftertax dollars and do a mega roth conversion. You put them in the very same investments. Now, you replay the loan with interest over the year.

You still have the problem that your interest payments (like your principal payments) after with after-tax dollars. But you would be getting some extra contributions in there. I really haven't thought this through and I'm sure it doesn't make sense as I've stated it and may even be impermissible under IRS rules, but it's a nugget of an idea.

MotoTrojan
Posts: 4189
Joined: Wed Feb 01, 2017 8:39 pm

Re: Using 401k Loans to increase contribution

Post by MotoTrojan » Wed May 15, 2019 7:09 pm

lkar wrote:
Wed May 15, 2019 7:03 pm
What about this though? Let's say that you are eligible to contribute after-tax dollars to your employer's 401k but don't have the funds to do so?

You borrow $20,000 from a 40lk, then contribute those $20,000 into the same fund as aftertax dollars and do a mega roth conversion. You put them in the very same investments. Now, you replay the loan with interest over the year.

You still have the problem that your interest payments (like your principal payments) after with after-tax dollars. But you would be getting some extra contributions in there. I really haven't thought this through and I'm sure it doesn't make sense as I've stated it and may even be impermissible under IRS rules, but it's a nugget of an idea.
Do you really come out ahead if you are always a year behind? Something like this would require you to also have a $20K windfall coming the following year, otherwise the short-term boost isn't compounding or lasting.

Also post-tax interest into a pre-tax account is not a winning solution (double-tax).

Braje
Posts: 55
Joined: Wed Jun 03, 2015 10:06 pm

Re: Using 401k Loans to increase contribution

Post by Braje » Wed May 15, 2019 8:15 pm

I think you are over estimating the amount of interest you would accrue. If you pay back the loan in just a few months then the interest would be much less then if you took 60 months to pay off.

User avatar
Earl Lemongrab
Posts: 7124
Joined: Tue Jun 10, 2014 1:14 am

Re: Using 401k Loans to increase contribution

Post by Earl Lemongrab » Fri May 17, 2019 3:14 pm

David Jay wrote:
Wed May 15, 2019 10:31 am
Our 401K supplier also used the term “pay interest to yourself” when describing the 401K loan process. That is theoretically true but not operationally true. Typically the collateral must be placed in the most conservative treasury or stable value fund, where it can’t participate in stock market levels of return.
Where do you get the information that such is typical? It certainly wasn't at MegaCorp when I worked there.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

Miguelito
Posts: 250
Joined: Thu Feb 27, 2014 1:21 pm

Re: Using 401k Loans to increase contribution

Post by Miguelito » Fri May 17, 2019 3:37 pm

Also, the more obvious impact is that you just pulled $50k from the market.

Frankly, this not something I would recommend.

User avatar
Earl Lemongrab
Posts: 7124
Joined: Tue Jun 10, 2014 1:14 am

Re: Using 401k Loans to increase contribution

Post by Earl Lemongrab » Fri May 17, 2019 4:01 pm

Miguelito wrote:
Fri May 17, 2019 3:37 pm
Also, the more obvious impact is that you just pulled $50k from the market.

Frankly, this not something I would recommend.
Well, that's not a consideration for most. You just rebalance the 401(k) so that the loan is fixed income.
This week's fortune cookie: "Your financial life will be secure and beneficial." So I got that going for me, which is nice.

User avatar
grabiner
Advisory Board
Posts: 24174
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: Using 401k Loans to increase contribution

Post by grabiner » Fri May 17, 2019 8:45 pm

This only works if the 401(k) loan rate is higher than the rate on the low-risk investment in the account, and even then, the benefit is marginal, although it is better with a Roth 401(k).

For simplicity, say that you take a one-year loan from the 401(k), paying it back in a single payment. You remove $10K from a bond fund yielding 4%, and invest it in a muni fund yielding 3%. (This choice of investments is made so that you do not change your risk level; munis yielding 3/4 as much as taxable bonds usually have comparable risk.)

If the loan rate is 4%, you lose $100 on the deal, as you have $10,300 in your taxable account, and when you put $10,400 back, you are in the same position as if you had never taken out the loan.

If the loan rate is 6%, you spend $300 out of your taxable account to put $200 more in the 401(k) by taking the loan. For a Roth 401(k), you break even if your taxable investment would lose 1/3 of its value to taxes, which is possible over a very long time horizon. For a traditional 401(k), the 401(k) loses 25% of its own value to taxes, so you break even if your taxable investment would lose half its value to taxes, which is unlikely.

If the loan rate is 8%, you spend $500 out of your taxable account to put $400 more in the 401(k) by taking the loan. Now the break-even tax cost is 20% with a Roth 401(k), which is reasonable, and 40% with a traditional 401(k), which is still unlikely.
Wiki David Grabiner

Post Reply