Help with 401K loan math? Compared to HML?

Question

Hello, I would like some help understanding the math related to taking a 401K loan.
- I have a 401K which allows up to $50,000 loan for any purpose
- 6.5% interest
- time period can be 6 to 60 months
- it is paid back with bi-weekly payments taken from my paycheck (after taxes)

So originally, I thought 'oh great, a loan at 6.5% sounds good'. Now I'm realizing that even though I'm paying myself back, I'm using after-tax dollars to do it.

What's the real interest rate if you consider the after-tax component?

Wondering if a HML is actually better option if judging by the numbers only?

Any help is appreciated?

Wayne Brooks · Answer

@Matt Ferch Just because it’s coming out of your (after tax)  pay check doesn’t mean it’s not defuctable as a business expense. I’d you paid a plumber to repair your rental property, from your (after tax) personal checking account it would still be deductible.

Steve K. · Answer

@Matt Ferch

You're correct on the math. If you kept your full 401k invested, and the mutual funds happened to yield 6.5%, the incremental $50k left in the account would appreciate 6.5% and it too would be fully taxable when withdrawn.

If you borrow $50k, you pay back the 6.5% and it too goes into your 401k and is taxable at a later date when you withdraw. Yes, it will feel like you're paying 8% APR or so, due to taxes.

What are your alternatives? In your net worth, is there home equity that's less costly to access? The one time I used hard money, it was 10% apr and 2 points for 6 month loan....the lender was making 16% APR annually.

Note, some will argue that they are in real estate because it beats the stock market. Some like real estate because they don't trust the stock market. Some will even advocate liquidating your 401k and investing in RE.......with the idea that leveraged real estate can make 15 to 20% cash on cash and over time, you'll make up the difference. Most of these advocates, however, won't advise you to give up "matching" 401k deposits (if your employer offerst that)

Brandon Roof · Answer

Two additional things you have to take into account:

How will that $50,000 would perform if you didn't take it from your 401k.  This will depend on the type of investments you have it in currently.  If it's in equities or mutual funds and the market goes up, then it hurts the case for taking a loan even more.  If the market goes down or has a very timely pullback, then you may look like a genius.  If you are in money market or low-yield bonds then this consideration may not be as relevant.  The takeaway here is that it could be a very unpredictable variable.

Secondly, when you do take out a loan against your 401k, does your employer allow you to continue to make contributions (in addition to what you are paying back every paycheck), and if so, will they continue to match said contributions.  Many larger employers don't and this would be a significant strike against using your 401k.

Craig Jeppesen · Answer

The after tax pretax statement. You are not paying a higher interest rate but only potentially losing number is shares invested but this is only a maybe depending on the market.

Matt Ferch · Answer

@Craig Jeppesen

What part isn’t true?

Craig Jeppesen · Answer

This is not true. The money does not leave the 401k, it is just invested in a loan instead of a mutual fund. You take the money out and pay it back and nothing changes tax wise.

It really is a 6.5% rate that you pay yourself. The risk is opportunity cost. If the market goes up during the loan you are repurchasing shares at a higher price than you had purchased before so you would have fewer number of shares in the mutual fund than if you didn’t do the loan. But you also didn’t pay any interest to anybody so you save money on your rehab or purchase. You do have a small fee for the 401k loan and risk a tax bill if you get fired.

Michael Masters · Answer

I took out a 401k loan for a real estate purchase last year so I have given it some thought.  I'll give a fuller answer later but for now here are the tax implications:

(1) You are not losing out tax-wise on the principle from taking out a 401k loan.  You are borrowing $50k and putting $50k back in, so no loss there.  Yes, you will eventually pay taxes on this amount when you take it out but you would have anyway.

(2) You are losing out tax-wise on the interest you pay.  This will happen when you eventually take it out.  The 6.5% interest you pay in was already taxed elsewhere and now you are putting it into a pre-tax account where it will get taxed a second time.

(3)  Loans from a 401k are NEVER tax-deductible.  Even if you use it for real estate investment, it cannot be claimed as an expense.  Someone above said you can deduct this, they were wrong.  I will find the tax-code and quote it for you later, its a special rule for 401k's.

More to come later.

Michael Masters · Answer

Your 401k administrator is wrong, you will have to pay it back by October 15th of the year following your departure from your company.  October 15th is the filing deadline for taxes after you request a 6-month extension.  So if you left your job on January 15, 2020 then you would have to pay off the loan by October 15, 2021.  This is not an option for your company to decide, it is a 401k rule.

Matt Ferch · Answer

I discussed this with the 401(k) administrator (Voya) and was told that if I left, I would just continue making payments, the only difference would be instead of it coming directly out of my check it would be payments that I would make as if it were another bill.

Dominick Austria · Answer

@Matt Ferch If you were to leave your job or be laid off, the 401(k) loan will be due in full by the tax return filing date. If you do not pay the loan back, then this will be considered an early distribution. You will assess a 10% penalty on the balance. I know you probably do not forsee leaving your job, but I think that should be taken into consideration as well. There is more risk associated with the 401(k) loan as opposed to a regular loan.

Help with 401K loan math? Compared to HML?

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