Comments on: Money for money

Question: Money for money

chickaboo — Tue, 01 Apr 2008 07:28:22 -0800

Is it a good idea to take out a 401k loan to pay off unsecured credit card debt, and how do these loans work?

By: Burhanistan

Burhanistan — Tue, 01 Apr 2008 07:40:01 -0800

They work by you borrowing against your own money. You'll have to do the numbers. Is the loss of interest accruing principal in your 401k more than the interest you'll be saved from paying on your credit card debt?

By: Daddy-O

Daddy-O — Tue, 01 Apr 2008 07:42:21 -0800

A serious "gotcha" to keep in mind is that if you change jobs the loan is immediately repayable. If you do not have the funds to repay, it counts as a distribution and will add the loan amount to your taxable income for that year. I am pretty sure there is a 10% penalty also.

By: chickaboo

chickaboo — Tue, 01 Apr 2008 07:49:21 -0800

ah
Well since my 401k isn't earning much right now anyway I wasn't so worried about the loss of interest. the immediate repay if you change jobs might give me pause.

By: Burhanistan

Burhanistan — Tue, 01 Apr 2008 08:03:20 -0800

By: domino

domino — Tue, 01 Apr 2008 08:04:19 -0800

you might ask your administrator about the language of your plan, as the pay it back immediately scenario isn't always true. in some cases, you may continue to pay it back but if you are 30 days late the loan is immediately called and counted as a distribution.

YMMV

By: beagle

beagle — Tue, 01 Apr 2008 08:16:47 -0800

The pluses:
1. You'll replace a high interest loan with a much lower interrest loan.
2. The interest you pay goes into your own 401K account.

The minuses:
1. You're credit card will be paid off, and you could be tempted to start charging again. So cut it up, if that's going to be a problem.
2. You're paying off short-term purchasing (gasoline, food, whatever you charged on the card) with a longer-term loan. If you can set this up as a 2-4 year payback on the 401K, that's not so bad (and certainly better than borrowing against home equity on a 10-year payment schedule to pay off revolving credit).
3. There is the problem, mentioned, that if you lose or leave the job, your plan may require immediate payment of the balance. Check on this. If the plan allows you to continue on the same payment schedule, no problem. If the plan requires immediate payment, you could just charge the cash on the card again and be no worse off than before.

By: gjc

gjc — Tue, 01 Apr 2008 08:18:51 -0800

It's a good idea IF you are going to pay it back. You have this asset, you might as well use it to its fullest.

My understanding of these kinds of loans is that the money remains in the account earning all returns it would anyway, the money you borrow is separate- a loan. It has low or no interest because it is very low risk for them (if you don't pay, they already have your money). It depends on the place, of course. But it can be a great way to borrow cheaply.

By: peep

peep — Tue, 01 Apr 2008 08:31:02 -0800

My understanding of these kinds of loans is that the money remains in the account earning all returns it would anyway, the money you borrow is separate- a loan.

WRONG WRONG WRONG. Not true.

By: Burhanistan

Burhanistan — Tue, 01 Apr 2008 08:35:17 -0800

Yeah, you're reducing your principal from your 401k, not getting the loan from some other source then using your 401k as collateral or something. So, less principal equals less interest. The OP said that wasn't much of a factor in his case, but definitely something to remember.

By: Grither

Grither — Tue, 01 Apr 2008 09:01:25 -0800

So if your 401k is currently getting negative returns (cause a lot of it is in higher risk stuff because I'm young) then this sounds like a pretty good deal, no?

By: iknowizbirfmark

iknowizbirfmark — Tue, 01 Apr 2008 09:28:54 -0800

Also factor in that your repayment will include 3-4% interest also. So, you're paying the bank to use your own savings. I think you can set the monthly repayment amount, so do yourself a favor and pay as much you comfortably can.

This has already been corrected, but it bears repeating that this is not generally (or ever, I think) true. You get the interest in your 401k after you pay it back. The only money you lose and never get back is a small loan fee, usually $100 or less. Check the terms of your plan.

By: theora55

theora55 — Tue, 01 Apr 2008 10:10:41 -0800

It's only an acceptable idea if you pay it back and don't accrue more credit card debt. Most people do this, then accrue more credit card debt. Are you really disciplined enough to stop accruing credit card debt? or will you let the credit card debt pile up again?

By: beagle

beagle — Tue, 01 Apr 2008 10:19:39 -0800

One more minus:
The timing is not great. If you take a 401K loan out at the top of the market, and then pay it back during the next cyclical dip, that's ideal -- sell high, buy low. Unless we go into a depression, money you take out now is not going to benefit from any gradual rebound in the markets, so there's that additional cost to this plan. Still, all in all I'd go for it if you'll avoid further CC debt.

By: EmilyClimbs

EmilyClimbs — Tue, 01 Apr 2008 12:54:19 -0800

So if your 401k is currently getting negative returns (cause a lot of it is in higher risk stuff because I'm young) then this sounds like a pretty good deal, no?

What it's doing currently (or in the recent past) doesn't really matter-- what matters is what happens between the day you take the loan out and the day you finish paying it back. If it continues to decline or stay roughly even, then yes, you'd likely come out ahead. But you would basically be gambling that the market is not going to improve significantly during the time you are playing the loan back. If it does improve, you miss out on that growth.

By: JohnYaYa

JohnYaYa — Tue, 01 Apr 2008 13:18:49 -0800

Another negative: you get a double tax whammy. The money you put in originally was pre-tax, but you'll be paying back your loan, plus interest, with after tax money. When you withdraw that money later in retirement, you'll pay taxes on it again. If you're in the 25% tax bracket, that's like taking out a loan at 33% interest (25% plus whatever the loan interest is, probably 7% - 8%). Your credit cards, bad as they are, probably aren't charging you that much.

By: JackFlash

JackFlash — Tue, 01 Apr 2008 14:23:57 -0800

Another negative: you get a double tax whammy. The money you put in originally was pre-tax, but you'll be paying back your loan, plus interest, with after tax money.

This is a commonly held myth, but isn't true, at least not entirely. The money you pay back for interest is double taxed. Therefore it is best to pay back with the lowest interest rate allowed by your plan.

But the principal is not double taxed. Borrowing from your 401k is just a temporary transfer your 401k account to your checking account. Some time later you transfer that same money from your checking account back to your 401k. There is no taxation involved.

By: tachikaze

tachikaze — Tue, 01 Apr 2008 15:11:02 -0800

I am pretty sure there is a 10% penalty also.

Yes, there is for all early withdrawals from 401ks.

What JackFlash said above. It is counter-intuitive but (from the tax perspective) the money with which you pay back borrowed principal into your plan is actually the same money you took out (even if you blew the loan proceeds on hookers and blow).

By: JohnYaYa

JohnYaYa — Tue, 01 Apr 2008 19:27:47 -0800

Not to derail, but I'm pretty sure about being doubly taxed. Let's say you take a loan for $1000 (ignore fees, etc). You buy $1000 worth of hookers and blow. You now have $30 a month deducted from your paycheck for the next 3 years to pay back the loan (you don't have a choice about that, that's how the loans work). That deduction is not a pre-tax deduction though, so you have to earn $40 less your 25% tax to pay back the 30 you owe each month.

Only if you take the loan but don't spend it can you still repay it with the pre-tax dollars (by making an early payoff of the loan). That seems to be the assumption people make in the arguments I've see for the money not being doubly taxed. If you had the money in savings though, why take the loan?

See here, about 2/3 down, here, and here.

By: tachikaze

tachikaze — Tue, 01 Apr 2008 20:15:13 -0800

JohnYaYa, that doesn't matter; a given dollar you have doesn't know if it's pre-tax or post-tax. Even if you had $0 money before taking the loan, by taking the loan you were still able to spend $1000 without going $1000 into debt.

The only way to prove this (to most people -- some people just refuse to believe the numbers) is to just run a simulation of how much tax is paid in the 0% interest case.

Case A: Have $0 in checking, $2000 in 401K, need $1000 for car repair.

Step 1: Borrow $1000 from uncle. Repair car.
Step 2: Save $5000 over 12 months, repay uncle the $1000 with "after-tax" money.

Now have $4000 in savings, and the $2000 is still in the 401K.

Case A: Have $0 in checking, $2000 in 401K, need $1000 for car repair.

Step 1: Borrow $1000 from 410K. Repair car.
Step 2: Save $5000 over 12 months, repay 401K the $1000 with "after-tax" money.

Now have $4000 in savings, $2000 in 401K.

The end results are identical. The "double taxation" issue is immaterial because you're not paying more tax to the IRS in Case B.

By: tachikaze

tachikaze — Tue, 01 Apr 2008 20:16:24 -0800

grr 2nd Case A should be Case B of course.

By: JohnYaYa

JohnYaYa — Wed, 02 Apr 2008 05:24:40 -0800

tachikaze, you're correct that there's no difference in the balance in your accounts, but you're still missing the double taxation. I agree that it has nothing to do with the interest rate.

In case A, when you retire and withdraw that $1000 you didn't borrow from your 401k, it gets taxed at whatever your tax bracket is. It's never been taxed before, having gone into the plan pre-tax, so you end up paying tax on it once.

In case B however, you took $1000 that had never been taxed, and replaced them with $1000 that has been, thus you've paid tax on it once. True, no difference in your account balance, but yes, there is a difference in tax. You had to earn $1333.33 at your job to get the $1000 to pay back, since it's an after-tax deduction. Then when you retire, you withdraw that $1000, and pay tax on it again at your current bracket. There's the double taxation.

By: tachikaze

tachikaze — Wed, 02 Apr 2008 09:04:59 -0800

and replaced them with $1000 that has been, thus you've paid tax on it once

The difference is that when you pay back the $1000 loan with after-tax money, you've either SPENT or otherwise STILL HAVE the $1000 "pretax" money so it's a wash, tax-wise.

People get hung up on the "double tax" angle but the numbers don't lie. At the end of the day it doesn't matter whether you pay the 401K loan back with the loan proceeds itself or with other money, there's no NET double-taxation. You're NOT paying the IRS more money for taking out the loan to yourself. I showed that above; in order to have paid more tax the numbers would have to be different.

Running the numbers with an eg. 5% interest rate would show the double taxation effect of paying interest into your 401K with post-tax money.