There are tons of articles out there waring about the dire consequences of borrowing from your 401(k) – you know, not earning money on the withdrawn amount, double taxation, early withdrawal penalties and having to repay immediately if separate from the company…I’m going to lay out why my particular situation and outline why none of these “risks” matter and my transaction will work out beautifully. So, be prepared for some unconventional wisdom!
First off, many people are either misinformed or irresponsible and would have been better off having NOT borrowed from their 401(k). But financial pundits like to compartmentalize ALL situations into a single bucket and paint something as “good” or “bad”. Generic cookie-cutter advice is often wrong and doesn’t apply to individual cases. My scenario is different and as you’ll see, I’m VASTLY better off borrowing from my 401(K) than not.
Why I’m Borrowing $50,000 from My 401K(k)
- Background – I have a pretty lucrative investment opportunity in real estate. I have a tenured partner who’s been investing in college campus student housing for years and there’s a decent-sized deal where we’ll go in as partners with our splits equivalent to our initial investments. He’s been making anywhere from 12-20% cash on cash returns annually and he’s turned his first initial 6 unit investment into several large units covering over a hundred students by now – but that doesn’t matter. What matters is the current deal at hand.
- Investment ROI – So, with conservative estimates of closing costs, annual maintenance, full knowledge of the existing rents, property manager fees, and such, we’d be looking at somewhere between 15-20% cash on cash returns for this deal. On top of that, there are of course, the principal paydown, depreciation/tax benefits, etc., pushing it to a “theoretical return” of 30% per year or more when factoring in those “paper” gains. But let’s be conservative here and say as low as 12% return net of all the items I just mentioned (extremely conservative and assumes A LOT goes wrong).
- My cash position – What differentiates my situation from the “textbook tisk-tisk” 401(k) borrower is that I could do this deal without borrowing from my 401(k). I have $20-$30K in the bank at all times for emergencies/other, and I have a traditional trading account with over $50,000 in it. I need a total of $50,000 for the upfront closing/investment costs. So, I could tap a mix of both and do the deal anyway – but I’d prefer not to.
- Why Borrow From a 401(k)? If it’s so damn taboo to borrow from a 401(k), then, why do it? Well, financially, using 401(k) funds will improve my ROI dramatically. Basically, I’m borrowing the money at an effective 1% (see below where I got that from) to make a double digit return on cash, and up to 30% annually over the long-term. That’s a hell of an ROI. That cash source is cheaper than liquidating stocks sitting on huge capital gains and paying taxes now.
Common Risks Cited in Borrowing from a 401(k) Account
Evidently, politicians are so intent on protecting us from ourselves, that there is actually legislation pending to outright prevent people from borrowing from their 401(k) accounts. That’s right, Congress wants to take an existing flexible option for people and eliminate it because we’re too irresponsible to manage our risks. Granted, many people are irresponsible and the default rate on borrowed 401(k) funds is high. But why should I be punished because other people are irresponsible. After all, maybe Americans shouldn’t be able to get home loans any more (even with rates dipping to incredibly low levels following the recent debt ceiling/market crash) – look how many people aren’t paying their mortgages! Same with credit cards – I guess we should ban them outright since millions of Americans are paying high interest card balances (see how I make $1000 tax-free annually with cash back rewards). But I digress… The common pitfalls cited with 401(k) loans are the following:
- Double Taxation of Funds – This is misunderstood nonsense. I’ve seen the biggest and the brightest financial “gurus” like Suze Orman and the rest of them warn against borrowing from a 401(k) due to “double taxation”. The thinking is that since you need to pay back those funds with after-tax dollars (usually extracted from your paycheck), and then you’ll be taxed on those funds again in retirement upon withdrawal, that it’s double taxed. This is a misnomer. The reality is, you’re paying an effective interest rate of about 1-1.5% to borrow these funds. That’s a hell of a deal! Here’s how. The “double tax” on the back-end is not accurate because you’d be taxed once on those funds anyway, so it’s a single tax on the back. On the front end, the after-tax money you have to pay yourself back is only your effective tax rate ON THAT INTEREST AMOUNT. So, say I’m in the 25% tax bracket and I borrowed the funds at 4%. Well, .25*.04 = .01. I’m borrowing money at a 1% interest rate. What bank is going to lend yo money to do whatever you want with at 1%? It’s really an incredible deal – IF you believe you can use the money to beat your investment options IN your 401(k) or you REALLY need the money and know you can pay it back.
- Paying Interest – This one shouldn’t even be on the list, but it is. The interest gets paid back to YOU! Not a financial institution, not your employer, but it gets paid back into your account and is factored into your paycheck deductions. The only nuance is that “double taxation” effect I just covered above.
- If You Get Fired or Leave the Company – Yes, you need to pay back the money, usually within 90 days, or you are assessed as a “default” and are subject to a 10% penalty and ordinary income taxes on the money owed. So, while this may be a risk to people who are borrowing these funds irresponsibly, in my case, I have over $50,000 sitting in a trading account, plus 5 figures in emergency funds and other alternatives (ongoing blog income, etc). So, in the event the unexpected happened and I had to repay the loan immediately, first off, the odds that it were to happen on the very day I took the loan are low. So, let’s say it’s $40,000 I owe back a year from now. I would be able to simply liquidate a suitable amount from my trading account OR use money from my cash holdings to pay it back – and by this time next year, all up-front closing costs, repairs, etc., will have been well-digested and if I chose to start taking payouts on my investment, that’s additional cash coming in. Granted, for someone with no other investments, no cash reserves and an iffy job situation, they could very well get burned. If that happend, well, yes, they’d get to keep the money. But on that $40K, they’d owe a $4K penalty and perhaps $16K in taxes, for $20K total. So in that case, it would be a whopper.
- Missing a Huge Market Move – This doesn’t concern me on multiple fronts. First off, I already have an equivalent $50,000 in a trading account (see how I recently Tripled the Return of the S&P500) which actually has a higher Beta than my 401(k) account, plus IRAs, plus 529 college plans, plus ESAs, plus plenty of other funds in that same 401(k) account. So, in the event I borrowed the money right when the market took off 50%, well, I’d make that money in my other accounts. The alternative over having sold all my stocks in my traditional account would be a wash – except I’m not paying taxes on all those capital gains (which is a key driver for this strategy).
What Are Your Thoughts?
Would You or Have You Ever Borrowed From Your 401(k)?