Borrowing from your 401k

[Mephistopheles]

My dad has his own small business with 401k plan. He's trying to come up with cash for an upcoming expense and trying to figure the most efficient way to do so. It's basically down to selling stocks in a taxable account (and paying capital gains taxes) vs. borrowing from 401k. I haven't done enough research on the latter but I see that the benefits are:

 

- He can charge himself a high interest and loophole way of contributing more to a 401k

- No taxes as long as the loan is paid back with interest in the set time frame (5 years is the law)

 

If anyone has ever done this would like to hear your thoughts. Unfortunately we can't borrow against the stocks in the 401k, right? Meaning, he'd have to sell shares to generate cash in order to lend it out to himself; as opposed to it being margin borrowing.

 

TIA

[fareastwarriors]

Why not take a margin loan on the taxable account instead? It seems way less complicated.

[sleepydragon]

I think taking a loan from 401k is not a good idea. In essence, it’s really not a loan. You are essentially selling your stocks (no capital gain tax), and you gave up future tax free growth. So it is slightly worse or better than selling the same amount of stocks in your taxable account holdings depending on if you have capital gains in that account.

 

It’s might be better to finance it with a real loan and try to pay it off ASAP.

 

 

[rkbabang]

If he has equity in a home I'd look into a home equity loan or line of credit before either of the above options.  You get lower rates than a personal loan and don't have to sell investments that you don't want to sell. The second option would be to sell in the taxable account and pay the capital gains. That's what savings is for right? To be there when you need it. Retirement accounts are for retirement, I wouldn't touch it until then and give up tax free growth.

[bookie71]

I believe the interest is not deductible any more.  It used to be and that made it somewhat favorable.  If he is unable to pay back, then he gets hit with an early distribution (tax plus 10% of the distribution, unless he is over 59 1/2.  I also think he must make payments at least quarterly.    (PLEASE check with his CPA as I've been out of the game for 5 years and things may have changed.  That said i used a profit sharing loan plus a seller note to buy our office building (but at that time you could deduct the interest).

I also like the idea that someone had to considering to use a margin loan.

[sleepydragon]

But I think if you have a view that SP500 is too high and will correct within a year,  and your 401k is invested in SP500, doesn’t hurt to borrow.

I am currently thinking to borrow from my 401k for buying a car but plan to pay it back by end of the year

[CorpRaider]

Yeah, as stated, setting aside the decision to incur the expense, it depends on what the foregone returns end up being versus the after tax cost of alternative sources of financing.

[Ross812]

I would argue the 401k loan is the best option provided you need 50k or less, have a stable job, and can pay the loan off in 5 years or less.

 

To compare you have to add the 401k loan rate to the HELOC/Margin rate:

 

i.e if the 401k loan rate is 4.5% and a HELOC costs you 4% then the market needs to return more than 8.5% annualized over the loan period to favor the HELOC.

 

If you can set your own rate, say 7%, or 10%, the probability of the 401k loan being superior is even higher. (Check with an accountant on the allowed interest rate) 

 

 

 

 

[johnpane]

I would argue the 401k loan is the best option provided you need 50k or less, have a stable job, and can pay the loan off in 5 years or less.

 

To compare you have to add the 401k loan rate to the HELOC/Margin rate:

 

i.e if the 401k loan rate is 4.5% and a HELOC costs you 4% then the market needs to return more than 8.5% annualized over the loan period to favor the HELOC.

 

If you can set your own rate, say 7%, or 10%, the probability of the 401k loan being superior is even higher. (Check with an accountant on the allowed interest rate)

 

That seems incorrect, sir.  You are posing two choices:

 

1) Take out a HELOC and receive investment return in your 401k. Using your hypothetical numbers, 8.5% investment rate minus 4% HELOC rate means you net 4.5%.

 

2) Take out a 401k loan and forego the investment return. You pay 4% on the 401k loan, and receive 4% return in your 401k from the loan. Net 0%.

 

If the market returns more than the HELOC rate you win by taking out the HELOC.

 

 

[sleepydragon]

The way I think about it:

1. Best not to borrow at all.

2. But I don’t want to sell my BrK  either.

3. So I sell some of my 401k which is invested in SP500 which is already up 10% YTD. If you can pay it back within 12 months it’s not bad.

 

[Mephistopheles]

Thanks for the replies. I think what you all are saying is making sense. It's not really worth it to borrow from 401k if that means having to sell down its holdings

[My Own Personal Hedge Fun]

My dad has his own small business with 401k plan. He's trying to come up with cash for an upcoming expense and trying to figure the most efficient way to do so. It's basically down to selling stocks in a taxable account (and paying capital gains taxes) vs. borrowing from 401k. I haven't done enough research on the latter but I see that the benefits are:

 

- He can charge himself a high interest and loophole way of contributing more to a 401k

- No taxes as long as the loan is paid back with interest in the set time frame (5 years is the law)

 

Since it's his own business, he doesn't have to worry as much about paying back the loan after separation of service (at any rate, since it is his own business then he can make sure his 401k plan states that loan payments may continue as scheduled after separation of service, and have the business cover any fees).

 

I would simply charge an average interest rate — no need to be an outlier and attract attention from the IRS, etc. Obviously it's better not to borrow from a 401k, but I think it's fine as long as it's an isolated event with a clear benefit and low risk of defaulting on the loan. The people who really hurt themselves with these loans are repeat offenders who cost themselves years of compounded returns.

 

If anyone has ever done this would like to hear your thoughts. Unfortunately we can't borrow against the stocks in the 401k, right? Meaning, he'd have to sell shares to generate cash in order to lend it out to himself; as opposed to it being margin borrowing

 

Yes. That would be borrowing on margin, which isn't allowed in retirement accounts. He could do a margin loan against securities in a taxable account, but frankly I think a 401k loan is the safer route in terms of a more predictable range of outcomes.