Taking out a 401k loan to pay down debt

[Libertarian01]

To PitBull88,

There are a lot of variations of thought here, all well intentioned.

Bottom line:

#1) Have your friend determine all (and I mean ALL) of the costs.
#2) Figure out which one will, at current trends, leave him with the most money at 65.
#3) Go with the option that leaves him with the most $$$ at 65.

Sounds simple? Taxes...? Interest...? Fees....? Self discipline...? Future needs...?

It is not simple. But the goalpost should be "In the long haul which of this choices leaves me on financially solid ground when I am ready to retire?"

I received my tax return yesterday and killed another credit card. Now I have only one (1) to kill. I do not have good self discipline so I cancelled all of my cards several years ago. In the long run this may have hurt me because it lowered my credit score by lowering my revolving credit. Good new = I have killed a hell of a lot of credit card debt. Bad news = My credit score has suffered and I may have problems getting a good rate on a mortgage.

Have your friend focus on the long haul.

Regards,

Doug

 

[dudley0]

Yes there are if he fails to pay it back.


Also if he loses his job he owes the whole amount taken out. There is no payment option other than full if that happens.

I took a five year loan out on my 401k. got down to the last six or eight months and took another loan out. Paid off the first loan, had 11K extra in my pocket and paid less in interest because of the rate change.

First loan was to pay on a rental property. Good investment. Second loan was to have as emergency cash because my job was ending.

I made the payments until the job ended and the company who has the 401k set me up on the same payment plan after the job ended. No penalties, no fees, no problems. 401k was not being contributed to any longer, but still getting the compound interest as well as my payments.

Time passed and I saw that I was not in dire need of the cash. I had the option to pay it back and switch to an IRA, or use it for other investments. I chose the latter.

Took a hit because of the 11k earned income with no taxes withheld. Will be a big one, of which my new accountant is sorting out now.

My full disclosure is that I never really intended to rely on the 401k as my retirement. Losing a bit on compound interest was worth it for me.

 

[CountryBoy19]

Alot of ides here, some good and some not so good.

Lets say you borrow from $1000.00 your 401k. When you borrow the money there isn't any fees. Remember though, when you contributed the the fund it was before tax dollars. When you pay the money back it is after tax dollars. So whatever tax bracket you are in, lets say 20%. Now lets move forward to retirement and you want to take money from your 401. You will pay taxes on the money you receive at the current tax rate. So you will pay taxes again on the money you borrowed and paid back. Remember the money you paid back to the 401 was taxed at 20%.

Now the loan doesn't look as good as it did when you took it out.

I am not a tax advisor, but I would encourage you to talk to a financial person that can explain this better than I can.

In the end, people have their ways of justifing what they do, the market is down, the gov. will eventually take it anyway..

My point is I would rather folks keep as much as they can legally without having to even pay one more dollar to the gov.

Just my ..

This is somebody to call
Core Wealth Advisors
Brad Good
317-497-0569 ext.102

Good point but the only thing that would be subject to being "taxed" twice in this case would be the interest no? Because the original $1000 loan you got from the 401k was not taxed, and therefore when it gets paid back, the taxes on that balance out. The only difference would be risk of tax increases meaning that "on paper" you lost a bit due to tax rate increases. That being said, isn't interest tax-deductible? So it would be deducted from your income taxes in the year you paid and therefore you break even again.

It's hard for me to explain, but if you want an example let me know...

 

[airishE]

More Americans are taking out 401(k) loans and most of them are defaulting on their loans. One of the reasons why they choose to take 401(k) loans, it is because they cannot qualify for regular loans to be used to pay for unforeseen expenses or to cover day-to-day bills. Yearly, many people are taking out 401(k) loan from their 401(k) plan, which they have to pay back. Unfortunately, not everyone is able to pay it back. Learn more: 401(k) loan defaults.

 

[PistolBob]

If you borrow 401K money to pay off debt you need to make sure you do not run that debt back up. If you borrow 15K to pay off credit cards and then run them back up, you're just screwing yourself.

 

[Hoosier8]

When you pay back your loan, you do so with post-tax (after-tax) dollars. Consequently, a $100 loan repayment reduces your take-home pay by $100. Worse, when you take the money out of your 401(k) plan during retirement, you will pay tax on the same money again. While a 401(k) loan has some benefits, its significant negatives ought to be avoided except during a genuine financial emergency. Still, if your only other source of money in an emergency is an outright distribution of your 401(k) money, a 401(k) loan is the preferable option.

You would be better of trying to find a zero or low interest rate introductory credit card to shift the debt to and keep swapping and pay zero interest while you pay back the debt.

 

[CountryBoy19]

When you pay back your loan, you do so with post-tax (after-tax) dollars. Consequently, a $100 loan repayment reduces your take-home pay by $100. Worse, when you take the money out of your 401(k) plan during retirement, you will pay tax on the same money again. While a 401(k) loan has some benefits, its significant negatives ought to be avoided except during a genuine financial emergency. Still, if your only other source of money in an emergency is an outright distribution of your 401(k) money, a 401(k) loan is the preferable option.

You would be better of trying to find a zero or low interest rate introductory credit card to shift the debt to and keep swapping and pay zero interest while you pay back the debt.

As I stated earlier, and I will repeat, the principal you repay into the loan is not taxed, only the amount you pay in interest. How can it possibly work that way?

Let me explain it because I think people missed it in my previous response.

You pay into your 401k with pre-tax dollars (for a standard 401k).
You take a loan out of your 401k, those are pre-tax dollars.
When you repay that money, yes, the amount you repaid is taxed, but because the amount you took out in loan was pre-tax, those taxes balance out to zero on everything except the difference from what you borrowed in principle and what you repaid in total (fees + interest are the only thing you are truly paying taxes on).

Example: I'm going to do this as if you have 2 separate accounts/balance sheets to keep track of taxed dollars and pre-tax dollars. You borrow $50k from your 401k as a down payment on a house. You never have paid tax on that $50k and you don't pay tax on it when it is loaned to you from your 401k. So your pre-tax balance sheet is +$50k of pre-tax dollars. You have $50k that you never paid taxes on in your hand. You loan that from your pre-tax account to your normal account to buy the house. You buy the house, life goes on, and you repay the loan. The $50k was paid back into your pre-tax account, it doesn't matter if you paid taxes on that or not, it was initially disbursed at the pre-tax value. The total loan amount you repay is $56k. Your pretax balance sheet is exhausted of that $50k pre-tax dollars and it's in the hole $6k. Your out-of pocket expenses that you pay tax on is only $6k. I hope that makes sense. It's kind of hard to wrap your head around...

 

[kolob10]

Discipline, discipline, discipline. That is the answer. Leave the 401K money where it can do the most good later in life. Sit down and formulate a budget. Stick to it. Cut out high cable bills, high phone bills, eating out, new cars, big houses, and buying popcorn at the movies. I raised eight kids on a meager income and am retired living well. I set goals and sacrificed where needed. It's really easy living in America. Learn to separate needs from wants. Educate yourself concerning the difference between an investment and an expenditure. Of course when medical bills, loss of job, etc comes along (and it will) it's prudent to have money put back to offset the costs.

I've lived in the same 1700 square foot house for 35 years, never had a new car, and currently have "0" debt. It's a good feeling! Lost my job at age 61 but I was prepared.

A wise man once told me that if I was not putting back at least 10% of my income then I would always be working for someone else. Yep, a second job or overtime is needed at times. There is no substitute for a good education and it should be a life long pursuit. I chose early on in this mortal existence to earn a life not a living. Living the dream!

 

[ArcadiaGP]

This is a very easy answer and doesn't need 5 pages to finish. The first response you got was the right one.

"No."

Never take out of 401k to pay anything off.

 

[actaeon277]

My 401k is how I got rid of my $25k credit card debt.
Bank said I was too far in debt. That was why I was trying to get a loan.
401k, no questions asked.
Not something I'd do for no reason, but credit card interest is too high, this loan cost me less than just trying to pay the credit card.

 

[skulhedface]

A 401k loan probably shouldn't be your first choice for paying off debt. However if the market goes down 08 style and you've "locked in" some of your gains now by taking money out, you could end up far ahead of where you'd be if you left the money in there. Right now, while you're likely up it may be a long term benefit provided that you pay it back and don't get smacked with penalties. If the market crashes then it's a no-go as you don't want to be locking in losses. There are a lot of risks and rewards to consider either way and anyone considering should probably go talk to a professional with hard numbers in hand and see if it's worth while. Personally, if it's a small amount of debt that I could pay off without the loan in two years time I would not take the chance on the loan. If it's more debt than that there's probably an underlying problem that needs fixed.

 

[Ryno300]

As I stated earlier, and I will repeat, the principal you repay into the loan is not taxed, only the amount you pay in interest. How can it possibly work that way?

Let me explain it because I think people missed it in my previous response.

You pay into your 401k with pre-tax dollars (for a standard 401k).
You take a loan out of your 401k, those are pre-tax dollars.
When you repay that money, yes, the amount you repaid is taxed, but because the amount you took out in loan was pre-tax, those taxes balance out to zero on everything except the difference from what you borrowed in principle and what you repaid in total (fees + interest are the only thing you are truly paying taxes on).

Example: I'm going to do this as if you have 2 separate accounts/balance sheets to keep track of taxed dollars and pre-tax dollars. You borrow $50k from your 401k as a down payment on a house. You never have paid tax on that $50k and you don't pay tax on it when it is loaned to you from your 401k. So your pre-tax balance sheet is +$50k of pre-tax dollars. You have $50k that you never paid taxes on in your hand. You loan that from your pre-tax account to your normal account to buy the house. You buy the house, life goes on, and you repay the loan. The $50k was paid back into your pre-tax account, it doesn't matter if you paid taxes on that or not, it was initially disbursed at the pre-tax value. The total loan amount you repay is $56k. Your pretax balance sheet is exhausted of that $50k pre-tax dollars and it's in the hole $6k. Your out-of pocket expenses that you pay tax on is only $6k. I hope that makes sense. It's kind of hard to wrap your head around...

The issue of repayment with post-tax dollars does result in being taxed twice UPON EVENTUAL DISTRIBUTION. Assuming a 20% tax rate, in your $50,000 example you only had to earn $50,000 to put that in pre-tax. In order to repay that loan in post-tax dollars you had to earn $62,500 (1st tax: $62,500 x 20% = $12,500). Now upon retirement as you draw that $50,000 out it will be taxed again (2nd tax) at your then current rate. If your tax rate is still 20% your $50,000 in distributions results in $40,000 ($50,000 x 20% = $10,000). Had you left the original $50,000 in pre-tax, the $10,000 taxation on your distributions would be the first time you paid taxes on it. Instead you paid $22,500. IANAFA

 

[CountryBoy19]

The issue of repayment with post-tax dollars does result in being taxed twice UPON EVENTUAL DISTRIBUTION. Assuming a 20% tax rate, in your $50,000 example you only had to earn $50,000 to put that in pre-tax. In order to repay that loan in post-tax dollars you had to earn $62,500 (1st tax: $62,500 x 20% = $12,500). Now upon retirement as you draw that $50,000 out it will be taxed again (2nd tax) at your then current rate. If your tax rate is still 20% your $50,000 in distributions results in $40,000 ($50,000 x 20% = $10,000). Had you left the original $50,000 in pre-tax, the $10,000 taxation on your distributions would be the first time you paid taxes on it. Instead you paid $22,500. IANAFA

Lets try this again, with more details to make it clear. You aren't following along completely.
Sticking with 20% tax rate and $50,000 principle amount I will give 2 examples. Both involve buying a house for $50,000, one using a 401k loan and the other would be some other way of paying. Both examples will ignore interest because it's mostly irrelevant to this disagreement and it overly complicates the explanation.

Example 1 (401k loan): You borrow $50,000 from your 401k. That money was never taxed and is NOT taxed when loaned out. You buy a house for $50,000 and repay the 401k loan with taxed dollars. It takes $62,500 in pre-tax dollars to repay the loan. The end result is that you have $50,000 equity in your house, $50,000 in your 401k, and you paid $12,500 in income taxes.

Example 2 (no 401k loan): You borrow $50,000 from a bank and buy a house. The money you borrow is not taxed because it is a loan (not income). You repay the loan with taxed dollars. It takes $62,500 in pre-tax dollars to repay the loan. The end result is you have $50,000 equity in your house, $50,000 still in your 401k, and you paid $12,500 in income taxes.

See a resemblance? That's because there is a resemblance. The resemblance is that there is no difference between the 2 until you throw in markets, interest rates, and other factors like interest rate on credit card debt etc. When you retire the tax rate is the same for both scenarios so it is irrelevant.

I also believe I misspoke above as well. I said that the only money that is taxed twice is the interest paid on the 401k loan. I don't believe that is true because loan interest is tax deductible so that also gets paid back into your 401k pre-tax and continues to compound without taxes.

 

[Robert8252]

Forum CU gave me a large credit card through them to pay off my high interest cards. 2.99apr for the first year and around 8%apr after that. Didn't have great credit and still got approved for it.

 

[Scott26]

General rule is only take loan against 401 is to avoid bankruptcy Anything else is does not make sense. my opinion only

 

[Hoosier8]

Lets try this again, with more details to make it clear. You aren't following along completely.
Sticking with 20% tax rate and $50,000 principle amount I will give 2 examples. Both involve buying a house for $50,000, one using a 401k loan and the other would be some other way of paying. Both examples will ignore interest because it's mostly irrelevant to this disagreement and it overly complicates the explanation.

Example 1 (401k loan): You borrow $50,000 from your 401k. That money was never taxed and is NOT taxed when loaned out. You buy a house for $50,000 and repay the 401k loan with taxed dollars. It takes $62,500 in pre-tax dollars to repay the loan. The end result is that you have $50,000 equity in your house, $50,000 in your 401k, and you paid $12,500 in income taxes.

Example 2 (no 401k loan): You borrow $50,000 from a bank and buy a house. The money you borrow is not taxed because it is a loan (not income). You repay the loan with taxed dollars. It takes $62,500 in pre-tax dollars to repay the loan. The end result is you have $50,000 equity in your house, $50,000 still in your 401k, and you paid $12,500 in income taxes.

See a resemblance? That's because there is a resemblance. The resemblance is that there is no difference between the 2 until you throw in markets, interest rates, and other factors like interest rate on credit card debt etc. When you retire the tax rate is the same for both scenarios so it is irrelevant.

I also believe I misspoke above as well. I said that the only money that is taxed twice is the interest paid on the 401k loan. I don't believe that is true because loan interest is tax deductible so that also gets paid back into your 401k pre-tax and continues to compound without taxes.

If you leave the 50K in the 401K over 15 years with an average return of 8% interest, you will have 158,608.

If you take it out and pay it back over 15 years at 5% interest, you will pay 71,172 and have 128,831 in your 401K with interest at the end of 15 years. You will have paid a tax of 17,793 because you will have had to make 494 a month to pay that 395 a month after taxes for the loan which you would not pay if you left the 50K in so in effect, the loan costs 71,172 + 17,793 = 88,965, now if you subtract the difference in what you would have earned leaving it in, that is another 29,777 so 88,965 + 29,777 = 118,742. Now subtract the 50K you took out = 68,742 which would be your cost for the 401K loan.

Now, if you buy a house at 50K and get a 15 year loan at 4%, which I just did, you will pay 369 or so a month and pay 16,571 in interest. Taxes on that 369 will be 16,605 so using the same idea as above you pay 33,176 at the end of 15 years on interest and taxes.

Interest gained on the equity of the house during that 15 years will affect both numbers equally so that is inconsequential.

So the difference in the 401K loan and a bank loan is 68,742 - 33,176 = 35,566 which will be the cost of the 401K loan over buying the house with a bank loan after 15 years.

 

[PistolBob]

8% - hahaha

Sure thing.

 

[Hoosier8]

8% - hahaha

Sure thing.

Easy, my average rate over the last two years is 12% per year.

 

[CountryBoy19]

If you leave the 50K in the 401K over 15 years with an average return of 8% interest, you will have 158,608.

If you take it out and pay it back over 15 years at 5% interest, you will pay 71,172 and have 128,831 in your 401K with interest at the end of 15 years. You will have paid a tax of 17,793 because you will have had to make 494 a month to pay that 395 a month after taxes for the loan which you would not pay if you left the 50K in so in effect, the loan costs 71,172 + 17,793 = 88,965, now if you subtract the difference in what you would have earned leaving it in, that is another 29,777 so 88,965 + 29,777 = 118,742. Now subtract the 50K you took out = 68,742 which would be your cost for the 401K loan.

Now, if you buy a house at 50K and get a 15 year loan at 4%, which I just did, you will pay 369 or so a month and pay 16,571 in interest. Taxes on that 369 will be 16,605 so using the same idea as above you pay 33,176 at the end of 15 years on interest and taxes.

Interest gained on the equity of the house during that 15 years will affect both numbers equally so that is inconsequential.

So the difference in the 401K loan and a bank loan is 68,742 - 33,176 = 35,566 which will be the cost of the 401K loan over buying the house with a bank loan after 15 years.

First of all, my post was to illustrate that you don't pay income tax twice on that money. Some are of the impression that you do, when in fact, you don't. Can it be argued that you're paying it twice? Yes, you can say that, but for ever penny that you pay double income tax on, there is a penny that you didn't pay any tax on (of the original principle, not including interest).

3points:
A: Your hypothetical is just that, a hypothetical, based upon average returns in the stock market. As previously discussed, taking a 401k loan is just like playing the stock market. If the chances of the markets dropping (your 401k decreasing) are strong then you may greatly benefit from taking the 401k loan. Also, you played this off as a mortgage and the OP is talking about paying off credit-card debt. The interest rate of the cc debt will very likely swing things the other way even in an above avg. year for the markets.
B: Your situation also neglected to account for interest being tax-deductible. While that is a small difference, it does paint the 401k loan to be worse than it actually is.
C: Your hypothetical also shows the numbers to be a very large difference because you figured a 15 year duration. I'm not sure how everybody else 401k works, but my equivalent to a 401k will allow a maximum loan term of 5 years so the difference won't be nearly as large.

 

[maxmayhem]

you made the right decision....the two offset each other in debt it sounds like....and the interest would eat you alive....just pay off the loan now...

My 401k is how I got rid of my $25k credit card debt.
Bank said I was too far in debt. That was why I was trying to get a loan.
401k, no questions asked.
Not something I'd do for no reason, but credit card interest is too high, this loan cost me less than just trying to pay the credit card.