Executive Summary
Borrowing money has a cost, in the form of loan interest, which is paid to the lender for the right and opportunity to use the borrowed funds. As a result, the whole point of saving and investing is to avoid the need to borrow, and instead actually have the money that’s needed to fund future goals.
A unique feature of a 401(k) loan, though, is that unlike other types of borrowing from a lender, the employee literally borrows their own money out of their own account, such that the borrower’s 401(k) loan repayments of principal and interest really do get paid right back to themselves (into their own 401(k) plan). In other words, even though the stated 401(k) loan interest rate might be 5%, the borrower pays the 5% to themselves, for a net cost of zero! Which means as long as someone can afford the cash flows to make the ongoing 401(k) loan payments without defaulting, a 401(k) loan is effectively a form of “interest-free” loan.
In fact, since the borrower really just pays interest to themselves, some investors have even considered taking out a 401(k) loan as a way to increase their investment returns, by “paying 401(k) loan interest to themselves” at 5% instead of just owning a bond fund that might only have a net yield of 2% or 3% in today’s environment.
The caveat, though, is that paying yourself 5% loan interest doesn’t actually generate a 5% return, because the borrower that receives the loan interest is also the one paying the loan interest. Which means paying 401(k) loan interest to yourself is really nothing more than a way to transfer money into your 401(k) plan. Except unlike a traditional 401(k) contribution, it’s not even tax deductible! And as long as the loan is in place, the borrower loses the ability to actually invest and grow the money… which means borrowing from a 401(k) plan to pay yourself interest really just results in losing out on any growth whatsoever!
The end result is that while borrowing from a 401(k) plan may be an appealing option for those who need to borrow – where the effective borrowing cost is not the 401(k) loan interest rate but the “opportunity cost” or growth rate of the money inside the account – it’s still not an effective means to actually increase your returns, even if the 401(k) loan interest rate is higher than the returns of the investment account. Instead, for those who have “loan interest” to pay to themselves, the best strategy is simply to contribute the extra money to the 401(k) plan directly, where it can both be invested, and receive the 401(k) tax deduction (and potential employer matching!) on the contribution itself!
401(k) Loan Rules And Repayment Requirements
Contributions to 401(k) and other employer retirement plans are intended to be used for retirement, and as a result, 401(k) plans often have restrictions against withdrawals until an employee retires (or at least, separates from service). As a result, any withdrawals are taxable (and potentially subject to early withdrawal penalties), and even “just” taking a loan against a retirement account is similarly treated as a taxable event under IRC Section 72(p)(1).
Yet unfortunately, the reality is that from time to time, employees may need to access the funds in their 401(k) plan before retirement, at least temporarily. To help address the need, Congress created IRC Section 72(p)(2), which does permit employees to take loans directly against their 401(k) or other qualified plan balance from the 401(k) plan administrator, subject to certain restrictions.
The first restriction on a 401(k) loan is that the total outstanding loan balance cannot be greater than 50% of the (vested) account balance, up to a maximum cap on the balance of $50,000 (for accounts with a value greater than $100,000). Notably, under IRC Section 72(p)(2)(ii)(II), smaller 401(k) or other qualified plans with an account balance less than $20,000 can borrow up to $10,000 (even if it exceeds the 50% limit), although Department of Labor Regulation 2550.408b-1(f)(2)(i) does not permit more than 50% of the account balance to be used as security for a loan, which means in practice plan participants will still be limited to borrowing no more than 50% of the account balance (unless the plan has other options to provide security collateral for the loan). If the plan allows it, the employee can take multiple 401(k) loans, though the above limits still apply to the total loan balance (i.e., the lesser-of-$50,000-or-50% cap applies to all loans from that 401(k) plan in the aggregate).
Second, the loan must be repaid in a timely manner, which under IRC Section 72(p)(2)(B) is defined as a 401(k) loan repayment period of 5 years. In addition, IRC Section 72(p)(2)(C) requires that any 401(k) loan repayment must be made in amortizing payments (e.g., monthly or quarterly payments of principal and interest) over that 5-year time period; interest-only payments with a “balloon” principal payment is not permitted. If the loan is used to purchase a primary residence, the repayment period may be extended beyond 5 years, at the discretion of the 401(k) plan (and is available as long as the 401(k) loan for down payment is used to acquire a primary residence, regardless of whether it is a first-time homebuyer loan or not). On the other hand, there is no limit (or penalty) against prepaying a 401(k) loan sooner (regardless of its purpose).
Notably, regardless of whether it is a 401(k) home loan or used for other purposes, a 401(k) plan may require that any loan be repaid “immediately” if the employee is terminated or otherwise separates from service (where “immediately” is interpreted by most 401(k) plans to mean the loan must be repaid within 60 days of termination). On the other hand, 401(k) plans do have the option to allow the loan to remain outstanding, and simply continue the original payment plan. However, the plan participant is bound to the terms of the plan, which means if the plan document does specify that the loan must be repaid at termination, then the 5-year repayment period for a 401(k) loan (or longer repayment period for a 401(k) loan for home purchase) only applies as long as the employee continues to work for the employer and remains a participant in the employer retirement plan.
To the extent a 401(k) loan is not repaid in a timely manner – either by failing to make ongoing principal and interest payments, not completing repayment within 5 years, or not repaying the loan after voluntary or involuntary separation from service – a 401(k) loan default is treated as a taxable distribution, for which the 401(k) plan administrator will issue a Form 1099-R. If the employee is not already age 59 ½, the 10% early withdrawal penalty under IRC Section 72(t) will also apply (unless the employee is eligible for some other exception).
Treasury Regulation 1.72(p)-1 requires that the qualified plan charge “commercially reasonable” interest on the 401(k) loan, which in practice most employers have interpreted as simply charging the Prime Rate plus a small spread of 1% to 2%. With the current Prime Rate at 4.25%, this would imply a 401(k) loan rate of 5.25% to 6.25%. And notably, these rates are typically available regardless of the individual’s credit rating (and the 401(k) loan is not reported on his/her credit history), nor is there any underwriting process for the 401(k) loan – since, ultimately, there is no lender at risk, as the employee is simply borrowing his/her own money (and with a maximum loan-to-value ratio of no more than 50% in most cases, given the 401(k) loan borrowing limits).
In fact, technically a 401(k) loan is really more akin to the employee receiving a (non-taxable) advance of their 401(k) account balance, as ultimately the plan administrator simply liquidates and distributes the employee’s own money to them, and the subsequent repayment of principal and interest simply go back to the employee’s account. In other words, the employee’s 401(k) loan repayments are really just making principal and interest payments to themselves (or rather, to their existing 401(k) account), not to a lender (as is the case with a traditional loan, or a “Bank On Yourself” life insurance policy loan). Though as a loan made by the employee to themselves, any “interest” repayments to the 401(k) plan are not deductible as loan interest, either.
On the other hand, since a 401(k) loan is really nothing more than the plan administrator liquidating a portion of the account and sending it to the employee, it means that any portion of a 401(k) plan that has been “loaned” out will not be invested and thus will not generate any return. In addition, to ensure that employees do repay their 401(k) loans in a timely manner, some 401(k) plans do not permit any additional contributions to the 401(k) plan until the loan is repaid – i.e., any available new dollars that are contributed are characterized as loan repayments instead, though notably this means that they would not be eligible for any employer matching contributions. (Other plans do allow contributions eligible for matching, on top of loan repayments, as long as the plan participant contributes enough dollars to cover both.)
In the meantime, it’s also notable that because there is no lender profiting from the loan (by charging and receiving interest), many 401(k) plan administrators do at least charge some processing fees to handle 401(k) plans, which may include an upfront fee for the loan (e.g., $50 - $100), and/or an ongoing annual service fee for the loan (typically $25 - $50/year, if assessed).
Nonetheless, the appeal of the 401(k) loan is that, as long as the loan is in fact repaid in a timely manner, it provides a means for the employee to access at least a portion of the retirement account for a period of time, without having a taxable event (as would occur in the case of a hardship distribution, or trying to take a loan against an IRA), and without any stringent requirements on qualifying for the loan in the first place, beyond completing the brief paperwork and perhaps paying a modest processing fee.
Why Paying 401(k) Loan Interest To Yourself Really Isn’t
Beyond the appeal of the relative ease of getting a 401(k) loan (without loan underwriting or credit score requirements), and what is typically a modest 401(k) loan interest rate of about 5% to 6% (at least in today’s low-yield environment), some conservative investors also periodically raise the question of whether it would be a good idea to take a 401(k) loan just to increase the rate of return in the 401(k) account. In other words, is it more appealing to “earn” a 5% yield by paying yourself 401(k) loan interest, than it is to leave it invested in a bond fund in the 401(k) plan that might only be yielding 2% or 3%?
Example 1. John has $5,000 of his 401(k) plan invested into a bond fund that is generating a (net-of-expenses) return of only about 2%/year. As a result, he decides to take out a 401(k) loan for $5,000, so that he can “pay himself back” at a 5% interest rate, which over 5 years could grow his account to $6,381, far better than the $5,520 he’s on track to have in 5 years when earning just 2% from his bond fund.
Yet while it is true that borrowing from the 401(k) plan and paying yourself back with 5% interest will end out growing the value of the 401(k) account by 5%/year, there is a significant caveat: it still costs you the 5% interest you’re paying, since paying yourself back for a 401(k) loan means you’re receiving the loan interest into the 401(k) account from yourself, but also means you’re paying the cost of interest, too.
After all, in the earlier example, at a 2% yield John’s account would have grown by “only” $412 in 5 year, while at a 5% return it grows by $1,381. However, “earning” 2%/year in the bond fund costs John nothing, while “earning” $1,381 with the 401(k) loan costs John… $1,381, which is the amount of interest he has to pay into the account, from his own pocket, to generate that interest.
Yet if John had $1,381 available to pay into the 401(k) account as loan interest, he also could have simply saved and invested that money for himself! In other words, John already has the $1,381 – inside of his 401(k) account as loan interest, or outside the account ready and waiting to pay. Except if he didn’t use it for “loan interest” to himself, he could have invested it for a return, too!
Example 2. Continuing the prior example, John decides that instead of taking out the 401(k) loan to “pay himself” 5% interest, he keeps the $5,000 invested in the bond fund yielding 2%, and simply takes the $1,381 of interest payments he would have made, and invests them into a similar fund also yielding 2%. After 5 years of compounding (albeit low) returns, he would finish with $5,520 in the 401(k) plan, and another $1,435 in additional savings (the $1,381 of interest payments, grown at 2%/year over time), for a total of $6,955.
Notably, the end result is that just investing the money that would have been paid in loan interest, rather than actually paying it into a 401(k) account as loan interest, results in total account balances that are $574 higher… which is exactly the amount of additional growth at 2%/year that was being earned on the 401(k) account balance ($520) plus the growth on the available additional “savings” ($54).
In other words, the net result of “paying yourself interest” via a 401(k) loan is not that you get a 5% return, but simply that you end out saving your own money for yourself at a 0% return – because the 5% you “earn” in the 401(k) plan is offset by the 5% of loan interest you “pay” from outside the plan! Yet thanks to the fact that you have a 401(k) loan, you also forfeit any growth that might have been earned along the way! Which means paying 401(k) loan interest to yourself is really just contributing your own money to your own 401(k) account, without any growth at all!
Taxation Of “Contributing” With 401(k) Interest Payments Vs Normal 401(k) Contributions
One additional caveat of using a 401(k) loan to pay yourself interest is that even though it’s “interest” and is being “contributed” into the 401(k) plan, it isn’t deductible as interest, nor is it deductible as a contribution. Even though once inside the plan, it will be taxed again when it is ultimately distributed in the future.
Of course, the reality is that any money that gets invested will ultimately be taxed when it grows. But in the case of 401(k) loan interest paid to yourself, not only will the future growth of those loan payments be taxed, but the loan payments themselves will be taxed in the future as well… even though those dollar amounts would have been principal if simply held outside the 401(k) plan and invested.
Or viewed another way, if the saver actually has the available cash to “contribute” to the 401(k) plan, it would be better to not contribute it in the form of 401(k) loan interest, and instead contribute it as an actual (fully deductible) 401(k) plan contribution instead! Which would allow the individual to save even more, thanks to the tax savings generated by the 401(k) contribution itself.
Example 3. Continuing the earlier example, John decides to take what would have been annual 401(k) loan interest, and instead increases his 401(k) contributions by an equivalent amount (grossed up to include his additional tax savings at a 25% tax rate). Thus, for instance, instead of paying in “just” $250 in loan interest to his 401(k) plan (a 5% rate on $5,000), he contributes $333 on a pre-tax basis (equivalent to his $250 of after-tax payments). Repeated over 5 years, John finishes with $7,434 in his 401(k) plan, even though the account was invested at “just” 2%, compared to only $6,381 when he paid himself 5% loan interest!
In other words, not only is it a bad deal to “pay 401(k) interest to yourself” because it’s really just contributing your own money to your own account at a 0% growth rate, but it’s not even the most tax-efficient way to get money into the 401(k) plan in the first place (if you have the dollars available)!
Why A 401(k) Loan Should Still Be For Need, Not Investing
Ultimately, the key point is simply to recognize that “paying yourself interest” through a 401(k) loan is not a way to supplement your 401(k) investment returns. In fact, it eliminates returns altogether by taking the 401(k) funds out of their investment allocation, which even at low yields is better than generating no return at all. And using a 401(k) loan to get the loan interest into the 401(k) plan is far less tax efficient than just contributing to the account in the first place.
Of course, if someone really does need to borrow money in the first place as a loan, there is something to be said for borrowing it from yourself, rather than paying loan interest to a bank. The bad news is that the funds won’t be invested during the interim, but foregone growth may still be cheaper than alternative borrowing costs (e.g., from a credit card).
In fact, given that the true cost of a 401(k) loan is the foregone growth on the account – and not the 401(k) loan interest rate, which is really just a transfer into the account of money the borrower already had, and not a cost of the loan – the best way to evaluate a potential 401(k) loan is to compare not the 401(k) loan interest rate to available alternatives, but the 401(k) account’s growth rate to available borrowing alternatives.
Example 4. Sheila needs to borrow $1,500 to replace a broken water heater, and is trying to decide whether to draw on her home equity line of credit at a 6% rate, or borrowing a portion of her 401(k) plan that has a 5% borrowing rate. Sheila’s 401(k) plan is invested in a conservative growth portfolio that is allocated 40% to equities and 60% to bonds. Given that the interest on her home equity line of credit is deductible, which means the after-tax borrowing cost is just 4.5% (assuming a 25% tax bracket), Sheila is planning to use it to borrow, as the loan interest rate is cheaper than the 5% she’d have to pay on her 401(k) loan.
However, as noted earlier, the reality is that Sheila’s borrowing cost from the 401(k) plan is not really the 5% loan interest rate – which she just pays to herself – but the fact that her funds won’t be invested while she has borrowed. Yet if Sheila borrows from the bond allocation of her 401(k) plan, which is currently yielding just 2%, then her effective borrowing rate is just the “opportunity cost” of not earning 2% in her bond fund, which is even cheaper than the home equity line of credit. Accordingly, Sheila decides to borrow from her 401(k) plan, not to pay herself interest, but simply because the foregone growth is the lowest cost of borrowing for her (at least for the lowest-yielding investment in the account).
Notably, when a loan occurs from a 401(k) plan that owns multiple investments, the loan is typically drawn pro-rata from the available funds, which means in the above example, Sheila might have to subsequently reallocate her portfolio to ensure she continues to hold the same amount in equities (such that all of her loan comes from the bond allocation). In addition, Sheila should be certain that she’s already maximized her match for the year – or that she’ll be able to repay the loan in time to subsequently contribute and get the rest of her match – as failing to obtain a 50% or 100% 401(k) match is the equivalent of “giving up” a 50% or 100% instantaneous return… which would make the 401(k) loan drastically more expensive than just a home equity line of credit (or even a high-interest-rate credit card!).
Nonetheless, the fundamental point remains: despite the classic view that 401(k) loan interest is a cost where you are simply “paying yourself”, the reality is that it’s not a direct cost at all, nor a prospective return. Instead, the true cost of a 401(k) loan is the opportunity cost of not having funds invested to grow (including the risk of losing out on 401(k) matching as well, if applicable), which can actually be an appealing cost relative to other borrowing alternatives for those who need a loan (especially those with credit scores in the 600s or below, who may not have any good borrowing alternatives!). Nonetheless, “paying 401(k) loan interest to yourself” will never be superior to just investing the money and generating any return at all!
So what do you think? Is a 401(k) loan really more akin to an employee receiving a (non-taxable) advance of their 401(k) balance? Do your clients seem interested in 401(k) loans? In what circumstances does it make sense to utilize a 401(k) loan? Please share your thoughts in the comments below!
I’d agree that these loans should be used very carefully, and infrequently. One situation I can think of is when buying a house. If the buyer is, say, $20K short of triggering PMI, and all other options have been exhausted, the savings on PMI, which as you know, is calculated on the full loan, not just the ‘shortage’ can be dramatic. This is a specific scenario, and the borrower needs to study the numbers carefully. As you warned, if this triggers a forfeit of matching deposits, I’d advise against it, and recommend eating ramen noodles for dinner until the extra money is saved.
Thanks — I didn’t think of this leveraged scenario to avoid PMI if a little extra liquidity is needed to get the deal done.
Michael – What about for high income earners that max out their 401k’s every year? For example – let’s say you max out the 18k limit in the first 3 months of the year (company has a policy that corporate match continue for all 12 months) – Does it make sense to then borrow $50k – invest that outside the 401k and use the fat part of the amortization table to increase the capacity of one’s 401k? My plan does not allow for after-tax contributions. Thanks!
Sorry – should have included the assumption that investments outside the portfolio mirror the asset allocation of the 401k (100% stock) and are held for at least a year to minimize tax hit…
This is actually a strategy I was brainstorming a bit when writing this article, but didn’t have time to fully model.
Stay tuned when I can delve in further and circle back. It’s an interesting idea for sure…
– Michael
This is an idea I have kicked around from time to time. Works ideal in a situation where the funds are roth 401(k) sourced (e.g. a plan without a match that has always been Roth funded) so that you avoid the conundrum of repaying with after tax dollars that transmute into tax deferred dollars. Though I suppose if the end game is charitable donation of the tax deferred dollars it is less important.
At the end of the day the taxable account, 529 or other options strike me as plenty good options to preclude chasing down this kind of optimization. Especially since the $50k is a hard limit not indexed to inflation, and the incremental contribution is the permitted interest premium on the $50k (less origination fees), possibly amortizing down over 5 years if your plan limits you to one loan at a time.
I agree with this…mostly. But picture 2007. You have a 10% credit card with a balance of 20k. Having borrowed against your 401k then to pay that sucker off, and been out of the market for the next 18 months while DCA’ing back in via loan repayments, would have worked nicely. If you kept your job, of course!
Lots of strategies look more appealing if you know in advance when the market is going to go down, and go to cash before that occurs.
Harder to apply in practice. 🙂 On average markets go up, which means on average this is a losing strategy to try…
– Michael
We’re financial planners, don’t we know in advance of market declines! 🙂
This is a JOKE for any compliance folks reading…
I agree 99%. Sometimes the person is already thinking about donating the qualified money to charity so by putting away more into a 401k by paying interest, they can accomplish that. The extra loan interest paid is taxable but it may not be taxable to the owner if they die. Then you have to look at the tax situation of beneficiaries. If a 80 year old leaves a slightly higher 401k balance to a 2 year old grandchild and you stretch it over the 2 years old life time, you will get much higher rate of return.
You also ignore that most middle folks use 401k loans to buy their first house and become eligible for many tax breaks. Most lenders don’t consider 401k loans in their loan affordability formulas( they really should) so this makes it easy for a couple to buy a house. Lets estimate they buy a house 2 to 3 years early because of the 401k loan. Over the households lifetime, 401k loans would work out nicely.
Now almost every advisor gets asked and shouId I borrow from 401k and payoff credit cards. From a rate of return perspective, sure go ahead and borrow from 401k however, if you are always spending more that what you are making, there is no way that strategy will work in the long run. You have to cut spending first or make more.
Here’s another way to think about it. My goal is to maximize the account balance in my 401(k) and the balance in my personal checking account. As an investor of 401(k) assets, if a 5% bond fits in well with my investment strategy and increases the likelihood of a larger balance, then I’m happy. On the household finance side, I want to minimize my interest expense on borrowed money. If a 5% borrowing rate beats a 24% credit card rate, then I’m happy.
Now, all the caveats from the post also apply (loss of job, taxes…), but thinking about a bond investment in your 401(k) as opposed to a loan to yourself may be a little easier to understand.
Actually, many plans move the funds collateralizing the loan to the fixed account for the term of the loan, where the money earns the fixed account rate and the interest paid represents a spread of 1 or 2%. With each payment, funds are moved back to the investment accounts.
Great illustration of the traditional thoughts about 401k loans for typical employees. However, the equation changes for those in a position to “over-fund” the accounts. There is still a risk for employees that are not sufficiently liquid outside the 401k in the event of a job change and need to pay back a loan in 90 days. However, for business owners with 401ks, even that risk is non-existent. For the business owner, the ability to make annual additions at $54,000 (plus a $6,000 catch up potentially) creates the opportunity to build a $50,000 line of credit for themselves as a contingency fund quickly. Even someone with a ‘side hustle’ can take advantage of this opportunity in job transitions by funding a 1 person 401k in lieu of an IRA, or plan roll in. I have several clients who’ve used funds for investment properties or home purchases as well as start up capital for entrepreneurial ventures.
Always reallocate the account after taking a loan – so asset allocation is at target levels, with loan as a fixed income investment.
No, interest you pay on a principal or second residence loan secured with a mortgage is tax defuctible. Further, Loan interest where the principal is Roth 401k monies is tax free if you meet Roth requirements.
Loans should only be used where there is a need for credit, but where it replaces a high cost (credit card or payday) loan, it may not increase retirement account balances as much as sourcing funds elsewhere – but it surely is effective at increasing overall household wealth. See 2nd qtr 2017 benefits Quarterly for loan information.
I believe that if the 401(k) account holder is maxing out their account, and is thinking of getting a loan, let’s say for a car, for example, and will not be adjusting their 401(k) contribution (many employer plans allow this), after getting a loan, it seems that borrowing from your 401(k) makes sense. In this situation, the 401(k) is still being maximized, the employer contribution is still being maximized, and the 401(k) account holder is paying themselves the interest instead of paying it to a third party.
The amount the 401(k) holder borrows will not generate any return while they are “loaning money to themselves”.
If the market goes up (which it does on average), the foregone return is the ACTUAL cost of their loan. In a bull market, which could be drastically more expensive than other borrowing options.
The “paying yourself interest” is effectively a mirage, because you both RECEIVE and PAY the interest. It’s a net return of zero. Your real cost is the return you don’t earn BECAUSE you’ve caused your returns to go to zero.
Whether the return you don’t earn is higher or lower than your borrowing cost will dictate the outcome. If your investment options are mediocre and your borrowing costs are high, the 401(k) loan may well turn out favorably. But it’s NOT because you paid yourself interest. It’s because it turned out to be cheaper to give up all upside and get a 0% return than paying third-party loan interest.
– Michael
Question Michael. What if I borrowed $50k from my 401k and invested the proceeds for a year, the account value is now $55k and I sold it in its entirety. What’s the basis? 0, $50k? Thanks!
Your basis is what you paid to purchase an investment – in this case, $50k.
Whether you buy it using money from your checking account, a loan from your 401(k), or a personal loan from me, is completely irrelevant.
– Michael
Remember index funds held for a long time gets you average returns. You don’t want to be average do you? Use puts and calls. Buy real estate because God ain’t making anymore land. All this horseshit is what wannabe Willy Lomans use to get you to take your money and gamble. Don’t gamble. Use the boring method of getting rich and forget the fast run.
Close, but a miss. You didn’t set up the appropriate logic comparison.
Start with the premise of you not needing the money at all. Then use 2 extreme interest rates and then you’ll see the purpose of the prime rate (hint: its to minimize tax arbitrage).
I borrow $50K from 401k I don’t need so where does it go? NQ Taxable brokerage account.
-So lets pretend for a second that we’re talking about traditional 401k 0% loan interest and invested in 100% capital gains assets.
-In such a circumstance, I would slowly liquidate my NQ brokerage account and pay the principal portion back to the 401k plan. The earnings portion has escaped the plan taxed at capital gains instead of future ordinary income rates. That is a net win and arbitrage.
-Lets instead assume you put it in 100% ordinary income assets in NQ account (bonds lets say). Well in that circumstance the tax status is equal OI in 401k plan later and OI in NQ brokerage. You only lose the taf deferral in the meantime. So net slight loss.
-Lets say you switch to 10% or 15% Traditional 401k loan interest, but stick with capital gains assets. In this scenario, you’re likely to under perform the loan interest rate and be forced to not only liquidate all of the capital gains NQ assets and put it back into the plan, but also come up with additional money and add it to the plan to cover the loan with no deduction.
-Now flip the scenario with a Roth 401k instead. 10% 401k interest and great I just increased my Roth contribution limit for the year as I’ll be forced to take more NQ funds that the earnings and principal on my withdrawal and add to the plan. Thats a net tax arbitrage win for me too assuming I already hit contribution caps.
-Stay Roth 401k and go back to 0% loan and I’ve made the mistake of exiting Roth assets back out to some NQ assets.
Set up all of these and you see the true purpose of the 401k loan rate… to minimize tax arbitrage. Depending on whether you’re borrowing from Traditional 401k or Roth 401k you either want to under perform or over perform the 401k interest rate in *this thought exercise.*
Only from there do you truly appreciate whats in the decision to take a 401k loan in lieu of some other credit souce (hint the comparison of avoiding a non tax deductible loan is a the same as buying a Roth owned bond of same rate and that of a tax deductible loan is a NQ bond of same rate).
And only from there are you then able to appropriately answer the far more common scenario but never asked question of “I want to buy x(usually a home) in several years should I either save that money up in NQ assets or should I increase my 401k contributions by same after tax amount (higher gross amount because of deduction) and 401k loan out when I make the purchase?” Because most Americans pick the wrong answer by default.
Man, I think you’re on to something here, but way too many numbers in paragraph form for me to follow. Can you spreadsheet this or something?
For a long time my contention has been that OI taxes on distro’s from qualified money gets WAY overlooked in planning, relative to CG or even qualified dividends in a taxable acct. Never mind the step up basis too as opposed to IRD!
I’d love to see your thoughts in an easy to follow read though.
I’m not a fan of 401(k) loans (keep retirement money for retirement), I do wonder about the beneficial effect it might have on saver behavior. Lots of folks pay down debt more easily than they save because they HAVE to make the debt payments, whereas saving is optional. So, while you mention that a person could simply save the 5% instead of paying it in interest on a 401(k) loan…would the person do that in reality? And if not, perhaps the 401(k) loan is in fact an effective way of getting the person to save more.
What this post and some of the comments below have taught me is that in the end during bear markets and the need to borrow money is mandatory then taking a loan out on your 401k is a sound stratgey. next bear market, i buy my home solar panels @solar city outright using a 401k loan, if I cannot “afford” it by then.
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I’ve been thinking about this quite a bit and I must say I’m missing something.
I posted a spreadsheet, anyone feel free to comment. The premise is the following:
Guy borrows $5k from his 401k. 120 payments amortized over 5 yrs at 5% interest means his payments are $47.
He takes the borrowed $5k and invests at 2%. After 5 yrs it’s worth $5520
He must also pay back the loan at $47 a pop. That goes into his 401k which is earning 2%.
After 120 payments that equals $5933. Those two combined equal $11453
Conversely, he leaves that $5000 in his $401k paying 2% but increases his contributions by $47 a payment.
I get a Future Value of $11459.
Just $6 more.
What am I missing here as it seems that if you have debt at more than 2% I don’t see why you wouldn’t borrow against your 401k to pay it off.
Obviously, taxes etc are not considered here.
thoughts?
The piece that you are missing is that you can contribute more than $47 – because the money is pre-tax – and it will still “feel” like $47. Essentially you get to contribute $47 +47*Marginal Tax Rate.
Good point Joe. But the money that comes out of the 401k is not tax free. So, if rates stay same etc. that should be a wash. Kind of like a Roth vs. Trad IRA analysis.
It makes sense to borrow from a 401 (k) in the event where:
1) The investors owns low yielding fixed income instruments such as BND or BNDI at 2% or so.
2) The investor has a loan outstanding with a cost above 3%-4%/year
3) The investor can borrow from their plan at a competitive rate around those 3% – 4%
In general, it makes no logical sense lend money to strangers by being invested in a bond fund with a forward return of 2%/year, but take loans that costs you more than 3%/year. Many times, it makes sense to keep contributing to a 401 (k), due to tax benefits, employer matching, and increased asset protection over taxable amounts.
All math aside. I think the point that is missing from this discussion is the behavioral finance aspect. In real world practice and in my experience once a client borrows from their 401k plan the first time and sees how easy it is. They can get easily tempted to do it again and again. Always finding a reason to borrow from this long term bucket to satisfy their current needs.
How many times has a client liquidated funds or borrow money from their 401k to pay off their “credit card debt” to only end up with a similar cc debt a few years later? I’ve seen it happen many times over.
Unless they are really disciplined…it’s an easy trap to fall into.
I usually advise against it in most cases just because i know the path it can lead down. And for some folks once they go down that path it can be very difficult to keep them disciplined and turn them around from a behavioral finance point of view.
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Lets count math. If I take 50K 401K loan at 4% interest to pay off a 50K credit card debt at 18% interest rate that is barely paying interest each month and never get paid off,…at lest for the 5 year loan term, the 50K credit card debt will be 100% pay off instead of being there forever asking 18% each year….there is no way your 401K can grow anywhere near that percentage year after year no matter what super fund you bought.
just make sure you paid off your high interest debt and not spend it.
Curious: couldn’t someone who “borrowed” $50,000 then invested it in stocks and bonds to earn say $5,000 of CURRENT INCOME in a year calculate the “$1,000” or so of “interest expense” and, if itemizing the return, view that as investment/margin interest expense and list it on Schedule A? Per the article above: “Though as a loan made by the employee to themselves, any “interest” repayments to the 401(k) plan are not deductible as loan interest, either.” Thanks!
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401k loans are over-powered, broken, provided you have a high income or are willing to “save” a lot.
Consider a scenario where someone makes a lot of money and whose 401k plan allows for contributions while paying off the loan. If they make enough to fully pay back the loan and still contribute the maximum, they will effectively be putting more money into their 401k than would otherwise be possible. Sure, the loan repayments are not tax deductible — not a problem if using a Roth 401k — but being able to instantaneously invest 50k in something a little more lucrative than limited 401k options can be better than holding that money in the 401k and waiting for enough paychecks to come through to accrue that amount to invest.
If we want to talk about forgone earnings, try the forgone earnings of someone who did not take out a loan and invest it in, say, the S&P500 this year. It’s up 25%+ from January 2021 to ~December 2021. Individual stocks have risen more (consider investing in Motley Fool recs, up 2x since the start of the pandemic). So the “bad scenario” where you take out a 401k loan and the market rises is offset if the loan you take out goes right back into the market. If the market falls, well then you’re getting to “contribute” “extra” to your 401k in a falling market, and the loan you took required you to sell positions *high* before they went *down* before buying them back *low*, something that any of these financial advisor guys would recommend anyway if possible.
You can’t time the market so you don’t know when it will go up or down, but in either scenario (loan + up or loan + down) you seem to be better off having taken the loan than not. In all scenarios (assuming full payback) you end up with more in your 401k at the end of the day than you otherwise would have and/or you end up with more money in your investments (and they pay off more than the 401k would have). And all those after-tax 401k paybacks? Roll them into a Roth IRA.
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Today, 2023, the interest rates are 6-8%, but most 401Ks are losing money in stocks and bonds. the reasoning above is good, except where a person is already retired, has a secondary 457 or 401K and wants a new car. Borrowing and paying yourself is an excellent choice. No worry of 10% fee if default, employer is no longer matching and you are no longer contributing. If making 2.60% on return, borrow and pay back 8% interest as mind is makes sense, otherwise you pay the interest to a bank.
Today, 2023, the interest rates are 6-8%, but most 401Ks are losing money in stocks and bonds. the reasoning above is good, except where a person is already retired, has a secondary 457 or 401K and wants a new car. Borrowing and paying yourself is an excellent choice. No worry of 10% fee if default, employer is no longer matching and you are no longer contributing. If making 2.60% on return, borrow and pay back 8% interest as mind is makes sense, otherwise you pay the interest to a bank.
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