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I’m Borrowing $50,000 From My 401(k) – It’s My Best Option!

by Darwin on August 14, 2011

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out there waring about the dire consequences of borrowing from your 401(k) – you know, not earning money on the withdrawn amount, double taxation, early withdrawal penalties and having to repay immediately if separate from the company…I’m going to lay out why my particular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)?

{ 21 comments… read them below or add one }

krantcents August 14, 2011 at 8:10 pm

Sounds like you really thought it through and you have a backup plan if necessary. Recognize that things can and will go wrong with income property. Students are a special class of renters, they tend to abuse things a little more because they never rented before and do not have any responsibility to take care it. This scenario means you may need cash reserves to take care of the units.

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Darwin August 15, 2011 at 10:09 pm

Oh yeah, these dudes beat the crap out of the houses. I lived in fraternity houses for 4 years, I know the deal. They’re cash flow machines but definitely budgeted for repairs!

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cashflowmantra August 14, 2011 at 10:25 pm

You have a brilliant plan, have thought about all the angles, and I agree with you 100%. I would do the same thing.

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Darwin August 15, 2011 at 10:09 pm

Awesome, thanks for the support!

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Roger Wohlner August 15, 2011 at 8:38 am

I’m one of the financial advisors who generally caution against taking loans from a 401(k). However, as an advisor, I know full well that every situation is different. Clearly you are not borrowing to buy a boat or a new refrigerator (I see this participant behavior in some of the plans for which I serve as advisor). It sound likes you’ve thought this out and have a backup plan in the event that you would lose your job, etc.

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Darwin August 15, 2011 at 10:09 pm

Yup, and it’s about diversification of asset allocation as well!

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Andy Hough August 15, 2011 at 3:05 pm

It looks like you have a well thought out plan for using your 401k loan. Unfortunately, most people don’t.

If you were referring to the SEAL Act it wouldn’t eliminate the ability to take out 401k loans it would just limit the number of loans that could be made. A 401k is supposed to be a retirement vehicle not a loan product so the restrictions seem reasonable to me.

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Darwin August 15, 2011 at 10:10 pm

I have to research it further; I thought there were some different bills being proposed, perhaps one that limits lifetime loans to 3 or something? 3 sounds like a lot, but I just don’t like the idea of the government placing restrictions on what I can do with my money – especially when there’s already a vehicle to do so.

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sandy - yesiamcheap August 15, 2011 at 3:09 pm

Borrow the money. I’ve done it before and paid it back. I did it for my investment property and it was the cheapest option for me AND I pay myself back an interest rate higher than what the market has returned overall in the past year that I’ve had the loan out.

As long as you have options for repayment, you’re good, and you already do. All advice can’t be cookie cutter.

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Darwin August 15, 2011 at 10:11 pm

Oh cool, you did the same thing! Glad it worked out (even if you have tenants from hell :>)

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retirebyforty August 15, 2011 at 4:08 pm

Good luck! It sounds like you have a good plan with a solid partner so hopefully it will work out well.
One question though – if you get fired, you will need that emergency fund right? I wouldn’t want to empty out the EF and pay back to the 401k. With 30% ROI, you’ll be able to pay back 401k pretty quickly and shouldn’t run into this problem as long as the job stays secure.

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Darwin August 15, 2011 at 10:12 pm

True, I do have over $50K in stock as well – hedged with short positions as well. So, in the event I get fired, get no severance, the market tanks and I can’t get a new job – all at the same time…. I should still be able to cover the payback with my stock portfolio, use my emergency fund to live on – and that doesn’t account for my blog income (or UI) at all!

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Moneycone August 16, 2011 at 7:42 am

If someone who knew or had little interest in finance came to me and said ‘I’d like to borrow from my 401K, what do you think?’ I’d say it is a bad idea.

But of course, if you are using capital to generate revenue, and have covered potential pitfalls, borrowing from your 401K isn’t a bad idea. The end goal is to maximize gains and minimize risk/penalties.

You have obviously thought this through!

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Buck Inspire August 16, 2011 at 8:49 am

I’ve heard the conventional advice before, but it looks like you’ve thought it through. Plus it looks like your returns will more than offset the loan. Also isn’t it conventional wisdom to have a nice emergency fund, too? Good luck on your deal and let us know how it goes!

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World of Finance August 16, 2011 at 8:43 pm

You’re right, it’s not a good idea for everyone. But, I think you’ve thoroughly analyzed your sitation and are focused on your ROI, which is important. Good luck on the RE venture… helps that you’re friend is experienced, definately decreases the risk factor.

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101 Centavos August 17, 2011 at 7:17 am

Good move, Darwin. I paid for part of our country property with a 401K loan. As long as you’re investing in tangible assets, it makes sense.
The “Double Taxation of Funds” myth propounded by alleged PF gurus makes my head spin.

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GoYanks August 19, 2011 at 11:12 am

So the principal that you pay back on the loan is with pre-tax dollars. Only interest is taxed. Correct?

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GoYanks August 19, 2011 at 12:21 pm

I think I figured it out. The distribution is not taxed, but you pay principal and interest back with after-tax money. So in effect, you are paying tax only on the interest – makes sense.

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Super Saver August 19, 2011 at 10:26 pm

In my analysis, it comes down to whether the market goes up or down while you are paying back the loan. If the market goes down (which is I think is likely), it’s a good idea. If the market goes up significantly, it’s a bad idea.

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Kevin@RothIRA August 31, 2011 at 5:00 pm

For most people, I think the standard advice to avoid borrowing against a 401k are pretty sound. You sound pretty investment savvy and you’re prepared to deal with the possibility that the arrangement may not have a happy ending. For the typical person though this could be a disaster for all the usual reasons.

One that I think is particularly troubling right now is the prospect of losing your job and having to pay taxes and penalties if you can’t repay the loan. Jobs are less stable now than at any time since the second world war, and the prospect of a 401k loan disaster can’t be taken lightly. Again, just my thoughts in regard to the majority of people.

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Vinod April 6, 2012 at 2:58 am

OK

You guys are wrong at one point. Let say you borrowed $500 from 401K and paid back $550. Here $50 is the interest you paid on the loan. You already paid taxes on this $50 amount once, and after retirement when you will withdraw this again you will be paying taxes on this amount. So you pay taxes twice on the interest amount that goes to 401K account with the principal of your loan.

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