the danger of a 401k loan

Real Estate Deal Analysis & Advice

the danger of a 401k loan

Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes

I'm sure it's been discussed before but I'd like to tell something I see (correct if I'm wrong):

a 401k loan should be among the last resorts for borrowing. reason being is you pay it back AFTER taxes. if you live in Illinois and are in the 25% federal bracket, that's 29%! and it's EVERY time you take a loan.

I did a home equity line of credit at 4% last year. I get to deduct it so the cost of the $ is around 3%? A TON cheaper than the 401k loan. a 401k loan is almost the equivalent of a hard $ loan.

oh, and you don't get to deduct the cost of paying those taxes back on your real estate investment.

IMO, a lot of people don't have a clue about their true cost of borrowing for this vehicle. it's not mentioned on the internet very much either.

there's a guy I know who is an underwriter for a bank and doesn't know about this; I feel bad for people who don't see the true cost of this.

search for private loans, bank loans before this. and make sure you know how much of a hit you will take. for a $50k 401k loan, that's almost $15k you eat!

if I'm wrong, please correct me!

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Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes

10y

What? When you pay back your HELOC you are paying back principal and interest with after tax dollars. You may be able to write off the interest paid if the HELOC is taken out on your primary residence.

When I pay back my SD 401K loan there are 2 costs: 1) opportunity costs for earning income in the 401K tax deferred (if you think the loan will offer a better return then discount this option) 2) The interest you charge yourself cannot be written off vs the HELOC (for a HELOC secured against primary residence).

The cost difference is the interest that cannot be written off but if you have a SD 401K the interest is going back into your account and presumably somebody else is paying that interest because you used the 50K for a down payment on income property.

I'll give you an example: for a 50K loan at 4.25% assuming tax bracket of 32%. The first year interest will be 1947.77 and writing off the interest in a similar HELOC would have allowed you to save 1947.77 *.32 = 623.29. The interest drops off as the loan progresses to year 5 which is a couple hundred bucks.

The cost of a SD 401 K loan through my provider (mysolo401k) was negligible. If you would like to know more of those details reach out to Mark Nolan here on the site.

At the end of the day this is another source of down payment funds which given my situation I believe to be better than a HELOC. My personal reasons: 1) The loan does not show up on your credit report. 2) The interest is going back to my account. 3) It was much cheaper to do and easier than a HELOC to obtain. 4) I thought that this was the highest and best use of these funds as I had the money sitting in a money market fund anyway as I'm a bit timid of the stock and bond market at this time.

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Reginald Pintang
Investor · Morton Grove, IL · Member since 2016 · 30 posts · 3 votes
10y
I believe thats correct. But if you roll the 401k funds to a self directed retirement account, like an IRA LLC, that allevaite the tax burden as well as offers liabilty protection for its assets. That is why there is so much talk of IRA LLC's. But you cannot take income off of an IRA investment. Please speak with a competent tax accountant regarding the taxation questions, as it is to lengthy to topic to disuss further. IRA LLC's can gains in value but not have income gains, if that makes any sence.
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Reginald Pintang
Investor · Morton Grove, IL · Member since 2016 · 30 posts · 3 votes
10y
Great discussion topic, I'd love to hear what others have to say.
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
the thing is, a lot of people on here are doing 401k loans at their employer and don't have a clue and how much they are getting clobbered.
the other thing is, with these loans, is they are amortorized over 5 years. HELOC is interest only. same thing with some personal/private loans. it's a no brainer.
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Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
10y
@Scott W.
You are absolutely correct. A 401k loan is very expensive money. There are a lot of folks here on BP that talk about taking 401k loans as if it is the best deal in the world, but they are missing the math.
When you put money into a 401k, you do so with pre-tax dollars. You earned $50K and that $50K went straight into the plan.
When you repay the loan, you are doing so with after-tax dollars. If your combined state and federal tax rate is 30%, then you have to earn about $71,400 to have $50,000 of after tax money to repay the loan. That is a $21K cost for a $50K loan. OUCH! It is somewhat hidden because that $21K does not come straight out of your bank account, but let me repeat, OUCH!
I've never paid that much for hard money.
It is correctly noted above that the interest paid to the plan (which might be about 3-5%) is not deductible.
If you are able to invest the 401k and earn 8%, then you are also giving up the ~3% opportunity cost of potential higher earnings to the plan.
If you lose your job with an outstanding 401k loan, you have to repay that loan immediately or it is counted as a taxable distribution with a potential 10% penalty for early withdrawal if you are under age 59 1/2.
The only reason Congress included the 401k loan provision when these plans were created was that they knew folks would not put money in unless there was a "safety value" that could be used in an emergency to pull some money out.
My company offers a Solo 401k plan that has a loan feature. We do not dangle this out there like free money, and make sure whenever someone asks about the loan that they are aware of the hidden costs of using such a loan.
With all of the above said, it can in some cases make sense to use the 401k loan feature, but if there is a huge upside to the project - getting started in a promising new business or something of that nature - and when other sources of capital are not available.
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
you'd really have to be desperate for a loan and would have to have an absolute grand slam to overcome the tax consequences.
I did a HELOC on a flip recently; 4% interest only on $47k and I paid it back in 8 months. I think I paid $1250 in interest. i can do that HELCO again and again at the current interest rate and deduct it.I am constantly told I'm an idiot - and don't know what I'm talking about - when I plead with people to try to not do the 401k loan due to the federal/state consequences.
and @Brian Eastman is correct - it's pretty much hard $/loan shark type of lending.
I even talked to a financial advisor who said I was wrong.
there should be a BP podcast on this and/or a blog posting.
people are getting taken to the cleaners; I can't tell you how many times I've read on here about people doing 401k loans. they think they are making all of this $. I made $19k on a flip recently and if I had gone the 401k $50,000 loan route, I'd probably make $5k after the interest.
1 Reply
Andrew Harris
Accountant · Eagan, MN · Member since 2015 · 19 posts · 5 votes
10y
It might depend on the 401k, but I thought that the benefit of a 401k loan is that you are paying interest to yourself, effectively no interest. From a net worth perspective that is ideal, it does present the cash flow problem you all have mentioned, but remember that the money is already pretax in that you may have saved 30% when you put it in and then paid no tax on the income. Another advantage is if you are already maxing out your elective deferrals, it is another way to get more money in a tax deferred account, so probably depends in individual situations....Just a couple of thoughts I had when reading the thread....
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John Chapman
Investor · Dallas, TX · Member since 2009 · 718 posts · 913 votes
10y
I'm struggling to follow the analysis of the original poster. You get the tax deduction for your 401k when you initially contribute to the 401k. But the loan itself is not a taxable event, like a distribution for example. If I borrow, say, $10,000 from a 401k account, and then immediately turn around and put it back in, then I haven't been harmed in any way.
I think the issue is the payment of the interest itself. Yes, you are paying the interest to yourself, but you are essentially taking your own after tax dollars and putting them in an account that will ultimately be taxed at ordinary income. That seems kind of dumb, but interest isn't huge on one of these loans. Is this analysis wrong? Am I missing something?
4 Reply
Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
10y
@John Chapman
Read the math in my earlier post. It should help.
The original $10,000 was pre-tax. You are then repaying the loan with after-tax dollars. it will cost you more than $10,000 of new earnings to have $10,000 of after tax money with which to repay the 401k loan. The difference is your tax rate.
Basically, you are forfeiting the initial tax-deferral on the 401k capital. it is like giving your 401k a negative 30% return (if you were in the 30% combined state/fed tax bracket).
0 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@John Chapman when you payback a 401k loan, it is coming out of your paycheck. as we know, a paycheck has taxes taken out of it.
that's where one gets screwed.
for a heloc/bank/any other kind of loan, you don't have to payback a loan after taxes.
the interest payback is paid back after taxes too but I dont' want to confuse anybody any more. :)
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John Chapman
Investor · Dallas, TX · Member since 2009 · 718 posts · 913 votes
10y
@Scott W. I understand that, but i guess at the end of the day, I'd submit it doesn't matter. If I borrow $10,000, and it's sitting in my bank account, what difference does it make if it's repaid from paycheck (after taxes) or from that account)?
Let me flip the question around a little, are you suggesting that the repayments of the loan should be tax deductible (i.e. pre-tax)? A 401k contributor has already received a deduction when he or she made the initial contribution. I don't understand why they should be able to take money out of the account (without triggering a taxable event) and then be able to get another deduction when they put they put the money back in.
1 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@John Chapman let me explain it to you in another way. when you take out a 401k loan, you pay back the PRINCIPAL and interest in an after tax form from your paycheck.
when I take out, say a HELOC or a private loan or a loan from a bank, only the INTEREST is paid back after taxes. I don't pay back the principal after taxes.
so that $50,000 loan you took out from the 401k, takes a HUGE hit.
next time you pay back a 401k loan, just look at your paycheck. you will see the principal and interest is paid back to you after the federal and state hits.
100% fact.
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Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
10y
@John Chapman
You put money in the plan pre-tax. $10,000 worth gross income was placed directly into the plan.
How much do you need to generate in gross income to have $10,000 of after tax money in your pocket?
If you are in the 30% combined tax bracket, that would be $14,285.
Therefore, the true cost of your loan is $4,285, not including the interest you pay to yourself (which is really just moving money from one side of the ledger to the other).
I don't know how to make this any more clear.
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David Teague
Arlington, TX · Member since 2014 · 13 posts · 14 votes
10y
I am new here but I have to agree with @John Chapman. It doesn't matter where the loan comes from (401k, credit card, bank loan, hard money), you still have to pay back the loan with post-tax dollars. The fact that your 401k balance is comprised of pre-tax savings has nothing to do with it.
The opportunity cost is the earnings you are missing while your loan is out. I believe you have to pay taxes on the interest the loan made, but not until you take it out in retirement.
here is an interesting article that addresses this point.
http://vanguardblog.com/2009/07/24/401k-loans-are-you-really-taxed-twice/
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@david t
@David Teagueundefined again, it all comes down to your costs of the loan. If I can get a heloc at $3k or a 401k loan at $15k, it's a no brainer. with the latter, you could lose $ on the deal but you wouldn't be able to "see it" unless you knew of the true costs.
1 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@David Teague also, the principal is not paid back on after tax dollars on most loans - just with a 401k loan. I can't stress this enough.
I guess people are going to believe what they believe; I'm trying to help not hurt.
0 Reply
David Teague
Arlington, TX · Member since 2014 · 13 posts · 14 votes
10y
Originally posted by @Scott W.:

@David Teague also, the principal is not paid back on after tax dollars on most loans - just with a 401k loan. I can't stress this enough.
Can you give me an example of a loan that is paid back with pre-tax dollars?
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Rick Mapes
Investor · Des Moines, IA · Member since 2014 · 44 posts · 33 votes
10y
I had the same thought, and I don't claim to be a tax expert, but aren't most loans generally paid back with post tax dollars?
2 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
no, with any other loan, the principal is just paid back. with a 401k loan, you pay it back after taxes are taken out of your paycheck.
if you don't believe me, the next time you do a 401k loan, look to see if that $50k payments were paid back dollar-for-dollar. they are not. they are paid back after your federal and state taxes were taken out. so now you're paying more to pay back the principal.
when I pay back a heloc, the principal is not paid back after federal/state taxes are taken out. you just give it back. same thing with a bank loan principal amount.
0 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@Brandon tu
@Brandon Turnerundefined should start a podcast, or blog post, on this topic. it's clearly a thing of confusion.
let me just say - I would LOVE to be wrong as I'd attack my 401k loan in a heartbeat. :)
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David Teague
Arlington, TX · Member since 2014 · 13 posts · 14 votes
10y
@Scott W. let's just walk through an example. Lets say I take out a HELOC for 10k and I buy a swimming pool with it. I now have a debt to the bank of 10k. I get my paycheck and I make payments until that loan is paid back. How is that not after-tax dollars being used to pay back the HELOC?
2 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@David Teague taxes aren't taken out when you pay back the principal on the heloc of $10k - just the interest. the principal just sits.
if I do a 401k loan of $10000, I pay it back out of my paycheck and - as you know - taxes are always taken out of a paycheck.
you've got a guy who runs a solo 401k company on here saying the same thing. IDK how one can argue with this.
0 Reply
David Teague
Arlington, TX · Member since 2014 · 13 posts · 14 votes
10y
@Scott W. sorry, I'm just not following. How does the principal just sit? (i understand its an interest only loan, but you still have to return the principal to make the interest payments stop).
Let's take the same example but this time its a credit card loan (you also said this is paid back pre-tax). I buy 10k of stuff on a credit card and now I owe 10k. I get my paycheck (tax withholding deducted) and I pay back the 10k. this is paying back the loan with after-tax dollars.
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@David Teague no, a credit card is not paid back with after tax dollars. just the interest. same with a bank, a HELOC, hard $. just different with a 401k loan. I agree, it appears illogical.
0 Reply
Andrew Harris
Accountant · Eagan, MN · Member since 2015 · 19 posts · 5 votes
10y
Originally posted by @Andrew Harris:
It might depend on the 401k, but I thought that the benefit of a 401k loan is that you are paying interest to yourself, effectively no interest. From a net worth perspective that is ideal, it does present the cash flow problem you all have mentioned, but remember that the money is already pretax in that you may have saved 30% when you put it in and then paid no tax on the income. Another advantage is if you are already maxing out your elective deferrals, it is another way to get more money in a tax deferred account, so probably depends in individual situations....Just a couple of thoughts I had when reading the thread....
0 Reply
Brian Liscio
Little Falls, NJ · Member since 2014 · 87 posts · 49 votes
10y
So... If I take out a company 401k loan it gays paid back post taxed directly out of my pay check
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