401(k) loan as a way to escape lousy 401(k) investment options?


R

Rich Carreiro

Have you ever considered the wisdom (or lack thereof) of using a 401(k)
loan as a way to put the 401(k) money into better investments than
the 401(k) plan allows?

Naive anlysis...

Pros: Aren't stuck with the lousy (grrr) options available
in the 401(k), so the better returns may make up for
the downsides.

Cons: Since the loan proceeds would have to be invested in
a taxable account, any income they throw off would be
taxable. And if person quits/is fired with an outstanding
balance on the loan, he probably will have to liquidate
the taxable investment to pay off the loan, incurring
even more tax liability.
 
E

Elle

Doesn't one have to repay a 401(k) loan within five years?
That's not a lot of time to be aggressive to the point of
ensuring a return (less tax effects) superior to that of the
401(k) plan's choices.

Also, don't some 401(k) plans restrict loans to certain
purposes? Not sure if that applies with your 401(k) plan,
but for the archives...
 
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B

Bucky

Rich said:
Have you ever considered the wisdom (or lack thereof) of using a 401(k)
loan as a way to put the 401(k) money into better investments than
the 401(k) plan allows?
While this is an intriguing concept, I don't think it'll work. I don't
know if these 401k loan terms are universal, but here are my terms:

1. There is a maximum of $50K. So if you have a lot more than that,
then it won't make much of a difference.

2. 4 year term, not very much time for volatility.

3. Loan is to be paid back monthly, so you would be limited to
investing in something that has a steady income stream.

4. You pay back the loan at an interest rate that is prime rate + 1%.
So if you earn more than that amount, you cannot put it back into your
401K, which means it'll be taxed. Which kind of defeats the purpose of
doing the whole loan thing. =)

Are you asking this question for yourself, or is this just a
hypothetical question? How bad can 401k choices be?
 
H

HW \Skip\ Weldon

Have you ever considered the wisdom (or lack thereof) of using a 401(k)
loan as a way to put the 401(k) money into better investments than
the 401(k) plan allows?
Before concluding that it's reasonable to think one could both cover
the costs of this idea (tax, possibly higher investment costs,
interest costs) and still whip the 401k, how about posting 1) the
names of those 401k investment choices and 2) the employer's matching
policy?

I realize that with your idea you would get the match anyway, but I'm
open to the thought that if the 401k choices really stink, perhaps we
should not rule out passing on the 401k altogether and setting up a
good private portfolio (diversified, low cost, tax efficient) and look
forward to capital gains and qualified dividends.

So.... how valuable is the match and what are the specific funds?

-HW "Skip" Weldon
Columbia, SC
 
T

Tad Borek

Rich said:
Have you ever considered the wisdom (or lack thereof) of using a 401(k)
loan as a way to put the 401(k) money into better investments than
the 401(k) plan allows?
Rich,
Boy those must be some lousy investment choices. Not even some
broad-market index kind of holding that you can "tilt" using assets
outside the 401k? Or some high-interest GIC that you could "transport"
your emergency fund to (figuring that you'd do the 401k loan THEN if you
needed a quick $30k, while your taxable investments were more aggressive
than you'd normally have them)?

One way to look at this is a sneaky way of making excess contributions
to your 401k - if that's something you want to do. As I'm sure you know
the interest you pay comes out of your pocket so if you borrow $50k and
pay, let's say, $12k in interest over the life of the loan, and isolate
just that aspect of the transaction, then you end up getting an extra
$12k into your 401k that is able to grow tax deferred. So if that's part
of the intent of the scheme - well it's a back-door way of increasing
your tax-deferred investment dollars. I've never seen someone do it for
this reason but the result is there right?

But the other aspects of the transaction, of course, are more
significant. Any advantage is going to be on the margins really, as your
"better" (but taxable) investments have a horse race with the 2.8%
annual expense Trained-Monkey Small Cap Growth Mutual Fund you would
have been forced to buy in your 401k. How likely is that to pay off and
at what risk? As you said there could be a situation where you need to
pay off the loan quickly and liquidate those taxable investments (or
some others) at a bad time. Not just job change/loss...what if your plan
provider changes, what happens to the loan? I'd check that in the plan
document as well. Basically, when do you repay it, what are the triggers?

I know you've probably run some mathematically-sound comparison analyses
on this, to see the taxable gains you'd need to obtain to make this
worth your time - what did that suggest?

-Tad

PS that was you in the NYT wasn't it...? Photo and everything, how bout
that!
 
E

Elle

Tad Borek said:
One way to look at this is a sneaky way of making excess
contributions to your 401k - if that's something you want
to do. As I'm sure you know the interest you pay comes out
of your pocket so if you borrow $50k and pay, let's say,
$12k in interest over the life of the loan, and isolate
just that aspect of the transaction, then you end up
getting an extra $12k into your 401k that is able to grow
tax deferred.
That occurred to me until I realized that meanwhile one will
have some $50k growing not tax deferred and not compounded
for X years. After the loan is paid back, the total in the
401(k) amount might easily be less, not more, vs. just
leaving it alone.

One really won't obviously come out ahead unless the return
on the loan (that went into the taxed, non-401(k)
investment) is very high and the tax bracket, low.
So if that's part of the intent of the scheme - well it's
a back-door way of increasing your tax-deferred investment
dollars. I've never seen someone do it for this reason but
the result is there right?
I suspect one needs to consider here that the raison d'etre
of 401(k)s is not just to help the employee avoid poverty
etc. in retirement but also to be a boon to the investing
companies that manage the 401(k) dollars. Why is there a
five year limit on repaying a loan, along with other
restrictions? Why the higher fees (generally) on 401(k)
vehicles (vs. their non 401(k) counterparts)? I suspect it's
in no small part to abet the enrichment of the sponsoring
company. It will give those matching dollars but only if it
can get a little something back in return, etc. Companies
give up profits if they give their employees the sort of
control over their 401(k)s that they have with their IRAs.
 
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R

Rich Carreiro

Tad Borek said:
Rich,
Boy those must be some lousy investment choices.
It's impressive, actually. It's all one or two Morningstars
and all "above average" risk. *sigh*.
broad-market index kind of holding
Nop.

outside the 401k? Or some high-interest GIC that you could "transport"
There's a GIC. With a mighty return of about 3.4%.
One way to look at this is a sneaky way of making excess contributions
to your 401k - if that's something you want to do. As I'm sure you know
After my post I came to that realization -- the interest on the loan
really ends up being a non-deductible contribution to the 401(k).
So on the surface that doesn't sound bad. However, despite being
the functional equivalent of a non-ded contribution, it still will
be taxed coming back out. So the second round of tax on that money
is a definite cost to a plan like this.
PS that was you in the NYT wasn't it...? Photo and everything, how bout
that!
Yep. T'was I.
 
B

BMS

Go read the plan document and see if it allows for in-service withdrawals.

You can take the money out and continue with the pretax deductions.

Never mind the loans.
 
J

jIM

If a 401k loan is taken, I see this as behaving more like a "bond" or
"stable value fund" and this increases risks while investing.

risk 1- job risk- if person loses job, loan must be repaid
risk 2- leverage- if 401k alternative was a bad choice, then little was
accomplished

benefit 1- leverage- money has been saved and could enhance a person's
net worth
benefit 2- a portion of 401k will have a known "return" (the loan).

the person "paying themself back" will have loan costs, interest costs
and would still have money invested in a bad 401k.

My suggestion would be if a 401k loan is taken, pay it back within 2
years. If you cannot afford to pay it back in two years, then you
borrowed too much money. My 401k plan allows loans to be paid over 10
year periods. I have taken a 401k loan for use as down payment on a
house, and the loan was taken for 14 months (all money will be repaid
within 14 months of when loan was taken).
 
E

Elle

jIM said:
My 401k plan allows loans to be paid over 10
year periods.
For any type loan?

What I saw on the net the other day were indications only
home loans from one's 401(k) may extend beyond about five
years for re-payment. Sounded like something written into
federal law.

Someone can ferret out the details.
 
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B

BreadWithSpam

Rich Carreiro said:
After my post I came to that realization -- the interest on the loan
really ends up being a non-deductible contribution to the 401(k).
Or looked at from inside the 401(k), though, it appears
as a bond paying you whatever rate you're interest is -
pre-tax - at the same time as, from outside the 401(k)
borrowing at that same rate. A net loss to taxes,
assuming that the investment outside the 401k appreciates
at the same rate as whatever would have been in the 401k
(ie. assuming away the "opportunity cost" of leaving the
money in the 401k)

Ask your 401k folks if there is a "mutual fund window"
provision. Mine has one, though I don't take advantage
of it because we have a pretty good selection within
the 401k. If they don't have one, it may be worth
agitating for. Or at least maybe starting a petition to
ask your company to add at least one or two decent
selections to the 401k. There's no excuse for them to
not have at least, say, a low-expense index.
 

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