Should I Borrow Against My 401(k) to Get Bond-like Returns in it?
Q. We took maximum loans against our individual 401(k)s because we knew our jobs were VERY stable. We charge ourselves the maximum interest, paying the loan back with after-tax money obviously. Since the interest rate is more than current bond yields, we feel this would be a good investment. I might miss bigger returns by not investing in equity market, but I have a higher yield than the bond market, and feel like I am exposed to less volatility risk. What do you think?
The Return is 0%. That Is NOT Bond-like.
A. You're not the first to think of this. Given the interest rates on 401(k) loans are Prime (currently 5.25%) + 1-2%, a guaranteed return of 6-8% on 401(k) money can seem pretty attractive. However, what you must realize is that the return on investment here is not 6%, it's 0%. The reason why is that you're paying the interest yourself. You pay 6% to yourself. So you pay 6% and you receive 6%. There's no extra 6% there. 6% – 6% = 0%. You had the same amount of money you had before. Let me explain.
- Imagine you had $10,000 in your 401(k) and $600 in a taxable account, for $10,600 total.
- Now you borrow $10,000 out of your 401(k). You now have $0 in your 401(k) and $10,600 in your taxable account, for $10,600 total.
- A year later, you pay the $10,000 back to your 401(k) along with the $600 in interest. Now there is $10,600 in your 401(k) and $0 in your taxable account, for $10,600 total.
Where's the investment return? That's right. There isn't any. Don't believe me because I'm just a doc? Would you believe Michael Kitces?
Technically it does allow you to put more money into your 401(k), since all of the interest paid does actually go into the 401(k). However, it's even worse than a non-deductible IRA. Not only do you not get a deduction for that interest paid into the 401(k), but it doesn't even increase the basis of the 401(k). You put after-tax money in, but when you take it out you have to pay taxes on it! That's a lousy deal. Essentially, that money paid as interest would be taxed twice.
Besides, even if this were a good deal, it would be a pretty limited one. You can only borrow out half of your 401(k), up to a total of $50K. So assuming only one 401(k) for you and one for a spouse, this would only work for $100K of your portfolio. That's a significant chunk of a $500K portfolio, but not of a $5M one.
401(k) Loans Are Not Double-Taxed
Please note, however, that 401(k) loan PRINCIPAL is not double-taxed, only the interest paid on that loan is taxed twice (once when you earned it at your job and again when it is withdrawn from the 401(k). This has been well-explained here, here, and here. Note that if you borrow from the Roth side of the 401(k), that double taxation doesn't occur, making the “deal” slightly better (although the return is still 0% and you've now lost the opportunity cost on a larger amount of after-tax money to get the same size loan.)
401(k) Loans Not As Bad As They Used To Be, But Still Bad
401(k) loans used to be really bad. If you had an outstanding loan and were fired or left the job, you had to have it paid back within 60 days or it would not only become taxable income to you, but there would be a 10% penalty due to the IRS. Thanks to the tax law changes made at the start of 2018, you now have until your tax return is due (including extensions) to pay the loan back without penalty. So if you took out a loan on January 15th of 2019 and then quit your job, you could have up to 21 months to pay it back. That's good, since about 10% of 401(k) loans were never paid back prior to the law change.
So if paying prime + 1% to your 401(k) provides a much lower interest rate than any other option you have, a 401(k) loan might still make some sense. However, a rule of finance is that those who receive interest generally come out ahead of those who pay it. That fact doesn't change just because you're borrowing your own money. There is a cost there and it's the same cost whether you spend cash you have, spend a bank's money, or spend money borrowed out of your 401(k). It's opportunity cost. Money used to consume can't be invested at the same time. (Technically there is an exception to that, but the downsides of that technique often outweigh the upsides.)
One Good Reason For a 401(k) Loan
Whitney is very proud of the box she made in her woodworking class. Afton thinks it's a great hiding place.
I can think of one good reason to take out a 401(k) loan. If your 401(k) sucks and you can't get your employer to improve it, you can still contribute to the 401(k), then borrow the money (up to 50% of balance or $50K, whichever is less) out of it and invest it elsewhere. If your only choices are crummy 3% ER loaded actively managed mutual funds, that could be a good idea. Note that the 401(k) has to be REALLY terrible for you to come out ahead, since you're basically now investing that money in a taxable account where tax drag (from capital gains distributions, dividends, and interest) occurs. If your 401(k) is really that bad, you might be better off leaving articles like this one around the office anonymously.
The bottom line is that there is no free lunch with a 401(k) loan, so don't kid yourself that you've discovered one. If you have to borrow money, it's not the worst way to borrow it, but I wouldn't make a habit out of it.
What do you think? Have you used a 401(k) loan? Why or why not? Comment below!
I am on the pension committee at work and it is sad to see the % of employees that have outstanding 401k loans out there because I too feel it is a very bad idea to use a 401k for your emergency funds, etc.
And it is not just relegated to non-physician employees as we have had requests from fellow docs wanting to do it as well. And despite thinking your job is stable there is no iron clad guarantee that it is (we have had 3 docs surprised in the past couple of years by being asked to leave and I am sure they thought there jobs were stable as well).
I didn’t even think about the double taxation of money regarding the interest component. I don’t see why that is even legally allowed (interest payments should really raise your basis as it is being put in with after tax money as you mentioned).
Our books are open to the other partners too and I’ve watched partners take 401(k) loans too. Never asked what they did with the money.
Well said, and thanks for addressing the double taxation myth as well!
What do you think about a 401k loan for someone who is just short of getting enough equity in their home to get out of PMI? While not bond-like returns in this fictional case either, at least you can pay yourself the PMI rather than the bank.
Sure, just pay it off quickly because you may be borrowing at a very high rate. You just don’t know.
Why does basis matter in a tax advantaged account?
Just in case you pull it out early and need to pay the taxes and penalty is the only reason I can think of.
It matters because you don’t pay taxes on basis when you pull it out.
I thought that basis does not have any effect on the tax when you pull out of an IRA, 401K, etc. I thought the whole amount that you pull out is taxes as income irregardless of the basis?
Are we not talking about the same thing?
Consider an IRA with non-deductible contributions in it. Basis matters. With a 401(k) loan though, there is no basis, you owe taxes on everything when you pull the money out. What the commenter above was referring to was how that is unfair. Nonetheless, that’s the way it is.
I used a 401k loan in 2017. I was selling my house and buying a new construction to live in. I wanted to use the proceeds from the sale for the closing on the new house, but the sale was delayed at the last moment and I needed to borrow from my 401k for the purchase. It was nearly another month before the sale closed and I was able to pay off the loan. I doubt I would have been able to purchase my home if not for the 401k loan. Being double taxed on the small amount of interest I paid was worth the convenience.
Well, that certainly supports the assertion that 401k loans aren’t generally taken for financially savvy reasons. If raiding your 401k is the only way you can swing closing on a new construction if the proceeds from your current house are delayed…can you really afford to be buying a new house?
I think it’s important to distinguish cash flow issues from affordability issues. That sounds to me like a cash flow issue. I mean, if you carry your argument out to an extreme it can be used against any type of debt.
Thank you for the thorough explanation!
What about using 401K to invest in real state? That would be a good article material. I always wanted to understand if that is a good idea or not since when you sell the real state, the profits wont be taxed as they are in the 401K.
You’ll have to be more specific. You can buy real estate in a self-directed IRA or 401(k). Or, you can buy it in a regular non-qualified “account” using money borrowed from the 401(k). Both have their pluses and minuses.
WCI it would be nice to see an article on it 🙂
I think it’s good to put stuff like debt investments in a retirement account, but equity investments can be pretty tax-efficient. I think those are fine in taxable.
Want to get into the weeds? Try this article:
https://www.therealestatecrowdfundingreview.com/single-post/2019/04/08/How-to-Invest-in-Passive-Real-Estate-Without-Paying-a-Penny-of-Tax-Legally-Part-4-Passive-Pairing-Details
I like the video. This is a nice touch, Jim. I like the logo at the top left of the screen, and the music at the end. When I set up our 401k plan, I made it so that no one could borrow against it. I also made it such that you cannot pick individual stocks and only low cost funds from Vanguard. There is a great book entitled “Nudge,” by Richard Thaler. He talks about how authority figures in government can set up policies that get the investors to do the right thing without forcing it on them, but nudging them toward the correct decision. I think the most important negative is the opportunity cost. The laws of probability dictate that money will be lost (by borrowing) in general as markets typically go up over time (and that borrowed money is not going up). Good job on the use of principal versus principle. I have to look that one up each time too. Another great book is “Make it Stick.” Every parent should read it. It is about how the science of learning can be used to your advantage. I use that book to help with me remembering principal versus principle. Are the videos going to be a regular part of the blog posts? What is the story behind it? Whose idea was it? It is a great, special, and nuanced touched. Happy investing! Looking forward to the audio versions of Boot Camp book—PCM
Video helps with SEO and the content is reused on the Youtube channel for those who prefer the video format.
401k is protected by creditors in many states. I wouldn’t take money out to non protected investment unless it’s a life time opportunity.
That’s not a particularly high risk, not one I spend a lot of time worrying about.
I think it’s more psychology than economics when one says the interest paid to one’s self on a 401K loan is double-taxed. Not all our money is after-tax money. Some subset of our money was not taxed, for example, the first $12K for a single filer, or gifts below $15K, or unreported gambling winnings. However, we mentally and actually commingle untaxed money with our other money and consider all our money in hand to be after-tax money. In contrast, we say we aren’t taxed on our basis when we sell stocks, but we could just as easily consider that capital gains tax to be spread over the entire investment. The double tax argument overly relies on how taxes are computed. I agree that a 401K loan is generally unwise but the “double tax” aspect of it seems inconsequential and not the main problem, which is potential opportunity cost.
I agree that’s the main issue.