401k loans to get more into a 401k?

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If you take a 401k loan you end up paying interest to yourself on the loan. This interest goes into your 401k account, and presumably can generate gains tax free.

My current loan options are 4.5%, 1 to 5 years. Disbursement fee of $25, no other fees.

Besides the time value of the money not being in the 401k does anyone else see any downsides?

TIA 

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Why start this thread then? Link to previous thread?

fwuser12 (Aug. 17, 2016 @ 11:46p) |

I had given green to this thread but the OP is now ruining it by shoeing in an investment with supposed 22% p.a. returns... (more)

ssgcinty (Aug. 17, 2016 @ 11:50p) |

This is dumb.

jaytrader (Aug. 18, 2016 @ 1:36p) |

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The borrowed funds aren't invested.  You only come out ahead if the market tanks.

Seems like a good time then no?

dcwilbur said:   The borrowed funds aren't invested.  You only come out ahead if the market tanks.
Let's complicate matters.  Let's say in March 2017, OP takes out a 401K loan for $11,500 and puts the money in his private custodian Roth IRA $5500 contributed for 2016 and $6000 contributed for 2017 (assuming the contribution limit gets raised in 2017).

Then in March 2018, OP pays back the loan to his 401K at 4.5% annual interest.  The interest would be in the neighborhood of just over $500 for the year, so keeping with round numbers, he pays back $12,000.  The $12,000 is money that he would have contributed to the Roth for 2016 and 2017, except that he used the loan money for those contributions.

Does the $500 in interest get sectioned off in the 401K somehow to prevent it from being invested?  What's to prevent OP from using this strategy to "contribute" more than the $18,000 annual limit (or $19,000, or whatever the limit is in 2018) to his 401K?  Does his contribution limit in 2018 get reduced by the amount of interest he pays to himself within the 401K plan during the 2018 calendar year?  What's the downside to doing this, if there is one?  Seems the only problem is opportunity cost, but if the loaned money is invested in an alternate retirement vehicle, that's not a factor.

dcwilbur said:   The borrowed funds aren't invested.  You only come out ahead if the market tanks.
  I suppose if you were planning on investing in a fixed income or cash option within the 401k, which very likely has an expected return below 4.5%, you can view the excess as an effective contribution.  Given 401k loans are capped at $50k IIRC, maybe that lets you contribute an excess $1k/year conditional on you investing it in cash instead of the market.  

Given current low-but-not-yet-negative interest rates, if you're going to hold low yield fixed income as part of your asset allocation, it's better to hold stocks in your retirement accounts and fixed income in taxable.  So trying to get a little more saved in your 401k this way may end up costing you a lot more when you owe capital gains on your taxable stocks instead of having them in your 401k instead of the loan.  Run the numbers if you actually are considering this.

Yeah, it's an interesting idea. In a way, when you want to use a loan to juice your 401k, the higher your interest the better! And you end up doing better (relatively) when the stock market is flat, or declines.

If you lose your job, the loan may be due within 2 months. Be sure you have an exit strategy. It may involve liquidating in taxable whatever stock fund/cd/bond fund you've parked your 50k assets in.

xerty said:   
dcwilbur said:   The borrowed funds aren't invested.  You only come out ahead if the market tanks.
  I suppose if you were planning on investing in a fixed income or cash option within the 401k, which very likely has an expected return below 4.5%, you can view the excess as an effective contribution.  Given 401k loans are capped at $50k IIRC, maybe that lets you contribute an excess $1k/year conditional on you investing it in cash instead of the market.  

Given current low-but-not-yet-negative interest rates, if you're going to hold low yield fixed income as part of your asset allocation, it's better to hold stocks in your retirement accounts and fixed income in taxable.  So trying to get a little more saved in your 401k this way may end up costing you a lot more when you owe capital gains on your taxable stocks instead of having them in your 401k instead of the loan.  Run the numbers if you actually are considering this.

Let's assume you have a big pile of cash that you're waiting to invest at the right time in your taxable account, or simply in a checking account at an outside bank.  That would make this a lot easier, would it not?  $200K in cash sitting there doing nothing, accessible at any time, could cover the payback of the $50K loan even if the market goes up...  If the market goes down, the investments will go down whether they're in a retirement account or a taxable account, so you could take the capital loss on whatever... assuming you had substantial investments in the taxable account before you started, you'd still have enough from the sale of those positions to pay back the full $50K loan AND get the tax benefit of a capital loss on your taxes.  If the market goes up, just leave the $50K loan invested in a taxable account and don't take the gains... use cash from the $200K pile of money to pay back the $50K loan with interest.  Sounds like if you're flush with a lot of cash and investments in the taxable account, it would be a no-lose situation.  Either way, you end up manipulating/hedging the system so that the dollars you contribute to the 401K are cash dollars at the bottom of the market, which helps inflate the overall value of the 401K account.  This seems like a much better way to time the market than buying and selling, which is really more like gambling.  What pitfall am I blind to?

dcwilbur said:   The borrowed funds aren't invested.  You only come out ahead if the market tanks.
Why do you think they are not invested?  Are you not allowed to?
What if you invest the 50k an ETF similar to the 401k ETF was in and never sell the investment till you retire ?

Your investment would grow at the same rate and will be subject to the same taxes. But you enjoyed an extra 4.5% every year. 
You can minimize taxable dividends by investing in tax-advantaged index fund.
Can you take the loan if the plan is Solo 401k?

(PS: Assume you have enough cash to repay the loan at any time if necessary.)

Edit: It seems the limit is 5 years.  But you can always pay back (without selling your taxable investment) and take a loan again.

Thanks all for the comments. Of course you can invest the loan in any vehicle you so choose.

I personally have cash on hand to repay, but since this is invested, and still very liquid, it is a non issue.

One downside is my loan plan only allows for 1 loan at a time with a max of 50% of the 401k value up to 50k.

If the APR was set-able to something higher, based on your ability to cover the monthly payments this seems like an amazing loophole. Also worth noting is that 401k loans do not require credit checks and do not show up as debt on your credit score since it is paid back to you.

Interested to hear what other people's plans offer.

When it comes down to it this is simply market timing.  It also doesnt take into account that the interest you pay yourself is double taxed.  Take extreme example:  borrow 1 dollar at 10000000% and pay back 1MM.  That 999,999 is post tax and will be double taxed at some point in the future.  So you've now taken your tax liability from $0 to $1MM dollars at some point in the future by paying yourself interest.

Example A:  You borrow your 1 dollar and load up your 401k with 1MM as payback.  You buy stock of company XYZ and hold until retirement.  You now owe marginal rate on $1000000+appreciation.
Example B:  You do nothing and instead take that 1MM in a taxable brokerage account and buy stock of company XYZ and hold until retirement.  You now owe marginal rate on just appreciation.

I'm not sure theres any example where doing this makes sense. 

ssgcinty said:   
dcwilbur said:   The borrowed funds aren't invested.  You only come out ahead if the market tanks.
Why do you think they are not invested?

I was referring to the fact that the borrowed funds are not invested within the 401k.  Looking at the 401k in a vacuum, you would only come out ahead if the 4.5% interest is higher than the return that your funds would have had were the funds still in the 401k.  Of course that does not take into account what you do with the borrowed funds.

If the goal is to get more into the 401k (as per the title), I'm still not getting it.  If I have $100k in the 401k, earning say, a 6% return, at the end of the year, I will have $106k.  Now let's say I borrow $50k and repay it at 4.5% interest.  At the end of the year, the balance in the 401K is $53k (the remaining $50k plus my 6% return), plus $52,250 (my $50k loan plus $2,250 interest), or $105,250.  How exactly do I end up with more in my $401k?  I must really be missing something.
 

pillsdoughboy1 said:   If you take a 401k loan you end up paying interest to yourself on the loan. This interest goes into your 401k account, and presumably can generate gains tax free.

My current loan options are 4.5%, 1 to 5 years. Disbursement fee of $25, no other fees.

Besides the time value of the money not being in the 401k does anyone else see any downsides?

TIA 

For a lot of 401k plans, the loan can become due in full if you leave your job (or it will convert to a fully taxable distribution). That can restrict a lot of flexibility.  

I'm sure I made some mistake somewhere in this hypothetical.

Total to start, August 2016:  $600K
$200K in 401K
$200K in taxable investments
$200K in cash

If you do nothing for the next 12 months except contribute another $18K into the 401K, and the market is flat, you'll have this a year later:
$218K in 401K
$200K in taxable investments
$200K in cash

If the market goes up 10% in that time, you'll have this:
~$239K in 401K (($200K * 1.1) + ($9K * 1.1) + ($9K * 1.0)) --- assuming approximately half of the $18K in new money will be in there long enough to be exposed to market conditions while the other half of the $18K will not
$220K in taxable investments (with at least $20K of unrealized gains)
$200K in cash

If the market goes down 10% in that time, you'll have this:
~$197K in 401K
$180K in taxable investments
$200K in cash

If you take out a $50K loan against the 401K and invest it in the taxable account, and the market stays flat, you'll have this:
~$220K in 401K (this would be comprised of the $150K you started with in August 2016 plus the $18K in new contributions over the following year plus the payback of the $50K loan plus the 4.5% interest of $2250)
$200K in taxable investments
$198K in cash

If the market goes up 10% in that time, you'll have this:
~$236K in 401K
$275 in taxable investments with substantial unrealized gains - This is because you started with $200K plus the $50K loan and your $250K went up 10% in 12 months
$148K in cash

If the market goes down 10% in that time, you'll have this:
$204K in 401K
$175 in taxable investments with a $5.5K realized capital loss and $19.5K unrealized capital loss (you started with $250K that lost $25K, then you sold $50K worth of shares to pay off the loan)
$198K in cash

Assuming my numbers are somewhat accurate, you win if the market is flat or goes down.  You lose slightly if the market goes up.  So then you just take out another loan for another year.    You time it so that you harvest losses and pay off the loan to yourself whenever the market is down substantially.  If it never goes down ---- YOU WIN!  Because you have lots of money.  If it tanks, you still win!  Sort of.

The interest portion of the 401k loan repayment is double-taxed. At a 25% marginal rate this is stupid. Make $1250 to pay $1000 to get $750 back. Your time horizon has to be long to overcome that via the tax-deferral.

There's a lot of confusion about 401k loans out there.  There are complex issues involved in whether you might be able to deduct the 401k loan interest on your personal taxes (hard), differences between if you have a traditional or Roth 401k in terms of future tax liabilities, and trade offs between benefiting yourself personally (borrowing at the best available rate for your loan) vs benefiting your 401k (investing in the highest return option).   If you actually care, I suggest starting with this discussion:

https://www.bogleheads.org/forum/viewtopic.php?p=693987

as well as those linked therein, and read with care especially the posts by LH2004, Bob is not my name, and myself.

dcwilbur said:   The borrowed funds aren't invested.  You only come out ahead if the market tanks.
  But you still have the funds to invest outside the 401k.  You can lock in a steady 401k return by transferring the risk to a taxable account.  Of course, then large gains will also be taxed.

jd2010 said:   When it comes down to it this is simply market timing.  It also doesnt take into account that the interest you pay yourself is double taxed.  Take extreme example:  borrow 1 dollar at 10000000% and pay back 1MM.  That 999,999 is post tax and will be double taxed at some point in the future.  So you've now taken your tax liability from $0 to $1MM dollars at some point in the future by paying yourself interest.

Example A:  You borrow your 1 dollar and load up your 401k with 1MM as payback.  You buy stock of company XYZ and hold until retirement.  You now owe marginal rate on $1000000+appreciation.
Example B:  You do nothing and instead take that 1MM in a taxable brokerage account and buy stock of company XYZ and hold until retirement.  You now owe marginal rate on just appreciation.

I'm not sure theres any example where doing this makes sense. 

  Roth 401k, even without a personal tax deduction on the loan interest paid.

centrifuge41 said:   Yeah, it's an interesting idea. In a way, when you want to use a loan to juice your 401k, the higher your interest the better! And you end up doing better (relatively) when the stock market is flat, or declines.

 

  Not quite. Let's say you were to get 4.5% flat in the market, or 4.5% via loan interest. What's the key difference here? If the funds are in the market and gain 4.5%, that's "free money." If you pay yourself the 4.5% via loan interest, that's YOUR money. Effectively, you either get 4.5% "free" or you put 4.5% extra in your 401k but you were the one paying out the 4.5% instead of the market.

Look at my numbers in just the situation if the market stays flat for a year. If you do nothing, you end up with $659K total, $218K of which is in the 401K. If you do the loan scheme, you end up with $659K total, $220K of which is in the 401K. If the 401K is exclusively Roth, this is good. If it's exclusively traditional, it's not.

Conclusions: If your 401K is exclusively Roth, or if you borrow and pay back strictly the Roth portion of it, you end up coming out ahead if the market is flat or loses ground. If the market goes up, you end up doing yourself a slight disservice, even if you're only dealing with Roth money exclusively. If you can pay back the loan and then immediately borrow it again, you can time the payback of the loan so that you only end up paying it back permanently when it's advantageous for you to do so, i.e., when the market is at or below the level it was at when you started. If the market continues to go only up for several years in a row preventing you from permanently paying it back, your overall gains will be so substantial that the slight disservice you've done to yourself will be negligible.

Finally, if you're borrowing from the Roth portion of a 457 instead of a 401, wouldn't the loan be tax-free, even if you were to fail to pay it back, assuming the entire borrowed amount was principal and not earnings?

jaytrader said:   
centrifuge41 said:   Yeah, it's an interesting idea. In a way, when you want to use a loan to juice your 401k, the higher your interest the better! And you end up doing better (relatively) when the stock market is flat, or declines.

 

  Not quite. Let's say you were to get 4.5% flat in the market, or 4.5% via loan interest. What's the key difference here? If the funds are in the market and gain 4.5%, that's "free money." If you pay yourself the 4.5% via loan interest, that's YOUR money. Effectively, you either get 4.5% "free" or you put 4.5% extra in your 401k but you were the one paying out the 4.5% instead of the market.

  But you also have the cash proceeds of the loan to help generate the 4.5% you are paying your 401k.  You're just transferring the risk from the 401k to your pocket.

I think people may have missed my initial thoughts around this, which was to get more $$ into a 401k, so that gains on it would be tax free. I'm in my 20s so 40+ years of compounding.

pillsdoughboy1 said:   I think people may have missed my initial thoughts around this, which was to get more $$ into a 401k, so that gains on it would be tax free. I'm in my 20s so 40+ years of compounding.
  
But you're not accomplishing that unless the market has a worse than average year, which means you are market timing.

Assuming you're talking about a traditional 401k where you will be eventually taxed, there's a trade off between the extra layer of tax (only on the interest) and the tax benefit of many years of tax free compounding.  Said another way, let's just ask a much simpler question:

How much would you pay to contribute an extra pre-tax dollar to your traditional 401k, above the current legal limits that apply to you?

the answer should be no lower than your (expected average retirement tax rate)*$1, and potentially higher if there's a long time until your retirement and your taxable investment options would incur a lot of tax liabilities.  If the time horizon is long enough, say investing in 3% bonds/CDs compounding tax deferred vs compounding at 2% after tax (1/3 tax rate), that will make up for the extra tax on the earlier contributions.  

Of course if what you really want is more IRA/401k money, the easiest way to get it is definitely NOT to fuss around with 401k loans capped at $50k.  You should set up your own company and look into making large employee after tax 401k contributions, or working on a side business where the employer contributions aren't limited across 401k plans the way elective deferrals are.

pillsdoughboy1 said:   I think people may have missed my initial thoughts around this, which was to get more $$ into a 401k, so that gains on it would be tax free. I'm in my 20s so 40+ years of compounding.
I never lost sight of it.  I just had to crunch some numbers to see if it would really work, and in a traditional 401K, it doesn't.  Look at my numbers.  The people saying you get double taxed on the interest portion are correct.  That's defeating the purpose of getting more money into the 401K to grow tax deferred all those years.

It's simple really - the original contribution (currently $18K/year) comes from your paycheck and it's in the left (untaxed) column on your pay stub.  The interest "contribution" comes from your bank account, which contains money that originally came from the right (taxed) column on your pay stub.

You are effectively taking money that has already been taxed and putting into an account that you're going to eventually have to pay taxes on again.

If your 401K is Roth only (or if you only borrow from and pay back the Roth portion of your 401K account) and the market stays flat or goes down during the borrowing period, you end up better off, i.e., you would have accomplished your goal.  If the market goes up during that time, you would end up worse off than if you'd done nothing.  But because the market would have gone up, so would your total portfolio balance in the Roth 401K.  And you wouldn't have to pay any extra taxes on any of it.  You'd just have more money outside the Roth 401K than you otherwise would have if you'd done nothing.  Combined with the possibility to keep the loan out in perpetuity (meaning you can pay it back in full whenever you want, preferably when the market is down from your starting point) this is a winning endeavor, but only in a Roth, and only if you don't lose your job, your company doesn't go bankrupt, and any other possible pitfalls are all avoided.  There's a good chance you'll come out ahead and accomplish your goal if you're smart and careful, but it's probably much more complicated than it's worth in the end.

DTASFAB - your example isn't counting future tax liabilities on the 401k and taxable investment accounts.  The advantage of tax free compounding only shows up if you count those carefully. 

xerty said:   DTASFAB - your example isn't counting future tax liabilities on the 401k and taxable investment accounts.  The advantage of tax free compounding only shows up if you count those carefully. 
I understand you may come out ahead in the long run because of this factor, but there are other variables in play.  Just look at the two examples of what happens if the market stays flat during the loan period.

Do nothing - flat market - result is you have $618K, of which $218K is in the tax-deferred retirement account
Do the loan - flat market - result is you have $618K, of which $220K is in the tax-deferred retirement account

Congratulations, you just made a $2K after-tax contribution to a pre-tax retirement account without the benefit of claiming that $2K on form 8606.

That $2K will grow tax-deferred, yes.  And it will grow faster than if you'd invested that same $2K outside the protection of the tax-deferred account, because you'd have to pay capital gains taxes every time you reallocate it to another position.  But we're talking such small amounts that if you have the cash on hand to make this loan/payback/excess contribution system work, you can probably afford to keep that $2K invested in a single position for many years, particularly if it's in a fund rather than an individual stock.  What you're really sacrificing is the option to reallocate your investment without paying tax on the gains right away.  Pick the right fund and leave it there, outside the retirement account.  That's a better system than taking out a loan and paying yourself back.

Roth 401K is a different story.  I think there could be a real potential benefit to doing this scheme in a Roth 401K.

pillsdoughboy1 said:   If you take a 401k loan you end up paying interest to yourself on the loan. This interest goes into your 401k account, and presumably can generate gains tax free.

My current loan options are 4.5%, 1 to 5 years. Disbursement fee of $25, no other fees.

Besides the time value of the money not being in the 401k does anyone else see any downsides?

TIA 

  
I consider this diversification of my 401K.  Whenever I need to borrow money for something, I speculate as to whether my holdings will increase or decrease in value over the course of the loan.  Unless I am confident my holdings will increase in value, I borrow from my 401k.  One other advantage is that failing to repay such a loan will not impact your credit rating.  You can always accelerate payback if the opportunity presents itself.  I took one 'Ready Loan' at $37 and paid most of it back when the stock was trading between $6 and $13.  Can you guess the stock?

you best hold up till after the nov. elections...i will say no more...T2016

jd2010 said:   
pillsdoughboy1 said:   I think people may have missed my initial thoughts around this, which was to get more $$ into a 401k, so that gains on it would be tax free. I'm in my 20s so 40+ years of compounding.
  
But you're not accomplishing that unless the market has a worse than average year, which means you are market timing.

  And if u could market time ... why do all this other running around.

owenscott said:   
jd2010 said:   
pillsdoughboy1 said:   I think people may have missed my initial thoughts around this, which was to get more $$ into a 401k, so that gains on it would be tax free. I'm in my 20s so 40+ years of compounding.
  
But you're not accomplishing that unless the market has a worse than average year, which means you are market timing.

  And if u could market time ... why do all this other running around.

  Because you can control and time the payback of the loan in a way that you can't control the market.  It's an indirect timing, so to speak.

Most 401Ks prohibit contributions until the loan is repaid. If you get a company match, you give that up.

Bad idea.

EradicateSpam said:   Most 401Ks prohibit contributions until the loan is repaid.
 

Most?  Gotta source for that?  

That would be a good thing to confirm, but I think it would be the exception rather than the rule. 

EradicateSpam said:   Most 401Ks prohibit contributions until the loan is repaid. If you get a company match, you give that up.

Bad idea.

  
Is that really true?

I keep hearing people claim it, but my 401k administrator allows contributions while there is an outstanding loan (which I know for a fact since they have taken both contributions and loan payback from my check the last 2 years)...and I don't recall seeing anyone on any forum that was considering a 401k loan actually come back with news that their 401k administrator doesn't allow contributions while there is a loan.

Obviously, if you can't contribute while there is a loan, that's a non-starter for this "technique". Separate from the idea that the technique isn't really beneficial in this case.

I never quite understood the getting double tax argument when taking loan out of 401k ... as swapping say $11.5K (from previous example).. taking it for a while and giving back.

What i do see a problem though ... the $500 payment you made for interest - on that $500 you'll pay tax twice. First you earned it, and you'll pay income tax on it. Then you put that into 401K as interest payment ... but when you finally withdraw it on retirement - you'll pay tax on that again. So same income - taxed twice for income tax purpose.

It is taxed no differently than any other interest, gain, or dividend in your retirement account. The fact you paid yourself interest (as opposed to paying it to an unrelated bank) does not make it double taxation.

hairybeast said:   It is taxed no differently than any other interest, gain, or dividend in your retirement account. The fact you paid yourself interest (as opposed to paying it to an unrelated bank) does not make it double taxation.
  Except that OP (and others) are arguing that they are taking the loan only to get the "interest" into the account as an extra contribution (not the utility of using the loan elsewhere).  In which case, it's certainly double-taxed and makes no sense at all to put post-tax money into a traditional account.

hairybeast said:   It is taxed no differently than any other interest, gain, or dividend in your retirement account. The fact you paid yourself interest (as opposed to paying it to an unrelated bank) does not make it double taxation.
  Sure it does. You'll be able to withdraw that interest you paid in (with post-tax dollars many years prior) and you'll be taxed on it. Whereas if you pay interest to a bank, not only did you pay income tax on it already but you'll never see that money again. Pick your poison. Double tax or never see a portion of the double taxed money again?

It's easier to just say that the 401k loan is typically not deductible, rather than talking about how many times it was taxed.  If you were clever and managed to arrange to have your 401k loan for investment taken only against your match or employer contributions (not against your elective deferrals), then maybe you could get the taxable interest deduction too.

is it common for them to allow loans against employer contributions (or Roth employee contributions)? I know my plan does not allow either of those, we can only take a loan against the employee contributed Traditional portion.
*We have no "match" though, there's instead a fixed percentage of salary that goes in as employer contribution regardless of any employee contribution.

Skipping 16 Messages...
This is dumb.



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