the danger of a 401k loan

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the danger of a 401k loan

Scott W.
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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Cory Adams
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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  • Bill ThompsonPro Member
    Rental Property Investor · Jamaica Plain, MA · Member since 2015 · 60 posts · 88 votes
    10y

    At the risk of beating a dead horse, I will add my two cents...

    Great conversation but a couple points still need clarification. 

    First, there seems to be consensus that ALL (not just 401k) debt service is usually paid with after tax dollars.  Notice I said debt service and didn't make a blanket statement about loan repayment.  Why?  Because a lot of investors, myself included, use 401k loans as short-term bridge money.  When I acquire a property, I typically borrow the max ($50k) from my 401k in lieu of an equivalent amount of hard money debt.  The savings on this transaction amounts to thousands... no points vs. 2% points, 3.5% interest rate vs 12% interest rate, $75 fee vs 1,000 - 2,000 in legal.  During the construction and lease-up phase (usually 6 - 9 months), I make my periodic payments (via payroll deduction) on the 401k loan.  When that phase is over I refinance to payoff all debt, including the 401k loan, therefore no payroll taxes are involved on this portion of the transaction.  This would be true for a "regular" heloc or construction loan as well.  401k loans can be a VALUABLE source of short-term bridge financing.

    Second, nobody talks about the timeline for repaying these loans. The typical loan term for non-owner occupied transactions is 5 years. If you borrowed $50,000 at 3.5% that would be a $910 monthly payment. What a cash flow killer! This is another reason most folks should consider using this a short-term bridge money as opposed to a permanent source of capital in their deal. HOWEVER, if you are looking to house hack you have found your golden goose. The loan term for owner occupied properties is up to 30 years!. The interest rate would probably be 3.5%. So there... you found down payment money for that multi you've been spying. You want the low down payment feature of FHA but don't want to pay 3.5 PMI for the life of the loan? Why not borrow from your 401K for your down payment and get a conventional loan?

    Finally, keep in mind what @Cory Tuck said about the real negative impact of the 401k being long term oriented.  It's true.  Only you can decide if the opportunity cost is worth it.  The point is with the 401k loan ya got options!  Be careful though.

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  • Jonathan Morrell
    Jersey City, NJ · Member since 2016 · 5 posts · 1 vote
    10y
    Originally posted by @Scott W.:

    @Brandon Hall  so, to answer everyone's question here, if I am in the 25% federal & 4% state tax bracket (29% total), and I take out a $20k 401k loan, will I wind up paying $5800 in taxes when I pay it back or $25,800 total with the principal?

    that's where the arguments are originating here. :)  hopefully you can answer it to clear up the brawl once and for all!

     You will not pay any taxes when you pay it back.  If you make 80k that year, you will pay taxes on the same 80k if you had not taken the loan.   You are correct you pay it back with after tax money, however every loan is paid back with after tax money.

    Say your AGI is 50k, with no 401k loan

    Say the marginal rate is 20%( I know that's not right I'm just using round numbers). 

    If you take a loan from a credit card for 10k at 5%, you pay back 10,500.  Your AGI remains the same.  

    You take a 401k for 10k at 5% you pay back 10,500.  Your AGI remains the same.  There is no tax consequence to this.    Your AGI remains the same

    The additional costs of the 401k loan are the taxes on the interest because if you had contributed them from your paycheck directly you would not have had to pay taxes. So in the case listed above you additional cost is (500*.20). If you are already maxing out your 401k contributions and IRA, that cost is moot. I would argue that you shouldn't count the opportunity cost, because if you are investing the money in real estate you should expect that your returns should be higher than what you are getting in your 401k or else you shouldn't be taking the loan.

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