Would you borrow short term from 401k to keep more liquidity?

16 Replies

Came across what appears to be a really great deal on 3 new SFUs from a single seller. These will be rentals #s 3-5 for me so I know what I'm getting into. Currently thinking I'm going to finance via 2 traditional mortgages and one though HELOC on my primary. I have the cash for the down payment and have the assets to cover the 6 months expenses but its going to spread me pretty thin. I know its generally discouraged to borrow from your 401k but I have a relatively stable job, we live on 50% of our household income and I could repay the loan within 10 months or less, it would just give me a little more breathing room. I'd be giving up about $300 in interest to make an additional $34k/year.

If its relevant, I'm 29, have about 1.5x my annual income in my 401k and want to build my real estate portfolio to supplement retirement since I plan to retire well before I'm able to draw on my 401k. 

If I don't borrow from the 401k, I might just take 2 properties, which would decrease the annual income to $24k -- still not bad but much less exciting!

Hi @Ashly B. .  Sounds like you have done a great job managing your $.  Congrats!  I would normally discourage folks from touching their 401, but in your case, I probably would go ahead and borrow from it.  What also played into my recommendation, is the frothy stock  market.  You may very well be 'buying' back at lower share prices.  Having your reserves in place, a stable j.o.b and your frugality, I would!  Keep us posted on this deal.  Sounds juicy!

A 401k loan is a lot like an upscale "pawn shop".  Usually it is a bad idea, however with a short-term money crunch it can be a very important option.  Your situation does sound like a good use of a 401k loan.

@Ashly B.

Sounds like you are on the right track. There are considerable advantages to taking a loan from your 401k for real estate investments, most notably that you pay the interest to yourself. If you are having success in RE investing, you may want to look at also doing investing inside of your retirement accounts as well. You can use retirement funds to invest in real estate and keep the entire process tax deferred. I don't think this would work for your current situation, generally 401k administrators won't let you roll funds out of the plan until you separate from the company, and I doubt that you have substantial funds outside of your current 401k at 29 (although if wrong, then you're a rockstar and awesome at saving for retirement.) But it is something to keep in mind for the future if you find that your RE investing produces greater returns than your more traditional retirement investments. 

Adam

everyone has their own opinion! That being said we seem to be in very similar situations! We are 27 and 28 live on one income and save the other we are currently working on closing 6&7 . We are also going to be stretched thin.

Our decision is to be stretched thing in our "cashless and save retirement/credit cards for emergencies. This way the retirement basket continues to grow (don't forget you need a reserve) and we can use our cash flow to shore up the accounts quickly. 

Everyone has their own references but I like to save these not so liquid accounts! Also when I'm "broke" I seem to work harder to be cheap and turn less into more!

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@Ashly B.

Here is the reason why a 401k loan is not generally a good idea.  You made contributions to the plan on a tax-deferred basis.  Basically, the government matched your contributions in the amount of your marginal tax rate.

When you borrow from the plan, you are repaying the principal with after-tax money.  As such, the interest rate on the loan is really the 4-5% of the loan PLUS whatever your tax rate is.  That is pretty darn expensive money.

My company offers self directed 401k plans that offer the loan feature.  We do not actively promote that loan feature - and often caution against its use -  because we think it is generally financially unwise to utilize the loan.  We could probably sell a few more plans if we did wave that "loan candy" around, but that is not what we are here for.

The only reason the 401k loan provision exists is because congress knew folks would not contribute to 401k plans if they did not feel there was a mechanism to pull funds out.

If possible, I suggest you operate without the 401k loan if you can.  Maybe you can find some private capital to borrow on a short term basis.  The 401k loan is there to bail you out if you need it, but try to keep it in that "safety valve" position if you can.

Medium safeguard rgb stackedBrian Eastman, Safeguard Advisors | [email protected] | 855‑997‑2298 | http://www.ira123.com

Thanks for all the input. 

@Brian Eastman Admittedly, math isn't my strong suit. Why is repaying the 401k with after-tax money any different than repaying any other loan @ 4.5%? I've read the argument that you pay tax on it twice but it doesn't align for me. If I borrow $10k of untaxed money, repay it with taxed dollars and withdraw it, taxed, at retirement age I've paid tax on $20k. If I don't borrow it and instead use say a HELOC at 4.5% I'm still repaying the money with after tax dollars (I don't factor the tax into the cost of the loan) and I'm still going ot pay tax on that $10k I never used when I withdraw it at retirement. Am I missing a piece in there somewhere?

Originally posted by @Brian Eastman :

@Ashly B.

When you borrow from the plan, you are repaying the principal with after-tax money.  As such, the interest rate on the loan is really the 4-5% of the loan PLUS whatever your tax rate is.  That is pretty darn expensive money.

I'm not sure I agree, Brian. The tax you pay on your earned income is a sunk cost. You pay it whether you take the loan from the 401k plan or not. You cannot add the two rates together and claim that's the cost of the money, any more than you could add it to the cost of groceries, if you instead chose to spend it on food.

The reason congress chose to include this option is also irrelevant. Could you imagine what our financial lives would be like if our investments were based upon their intentions?  Yikes!!!  Fact is, the option exists, and it should be used when it's in your best interest. Ashly presents one of the few cases where it might make sense to take the loan.

I'm actually with you though, and would not normally not a fan since the time value of the tax deferred money is huge, and likely much greater then the long term return on her property, if not repaid. If she is 1000% certain she can pull it off in a timely manner, then to me this makes sense.

@Ashly B.

The difference is not really the cost of the borrowing itself.  The 4.5% interest or thereabouts that the 401k loan will cost is what it is, and you are actually repaying your plan.

The issue is the hidden cost of replacing the principal itself.  If you are in the 28% tax bracket, you are effectively giving up the 28% credit that the IRS gave you when you initially contributed to the 401k.

If you earn $10,000 and elect to put that in your 401k, all $10,000 goes into the plan pre-tax.

To replace that $10K, you will need to create a touch over $13.5K in new earnings, pay the taxes on those earnings and then put the remaining $10K in the plan.

Medium safeguard rgb stackedBrian Eastman, Safeguard Advisors | [email protected] | 855‑997‑2298 | http://www.ira123.com

Originally posted by @Ashly B. :

Thanks for all the input. 

@Brian Eastman Admittedly, math isn't my strong suit. Why is repaying the 401k with after-tax money any different than repaying any other loan @ 4.5%? I've read the argument that you pay tax on it twice but it doesn't align for me. If I borrow $10k of untaxed money, repay it with taxed dollars and withdraw it, taxed, at retirement age I've paid tax on $20k. If I don't borrow it and instead use say a HELOC at 4.5% I'm still repaying the money with after tax dollars (I don't factor the tax into the cost of the loan) and I'm still going ot pay tax on that $10k I never used when I withdraw it at retirement. Am I missing a piece in there somewhere?

 Assuming you are in the 25% bracket and there isn't state income tax - you will have to earn $13,333 to pay off the principal of a 10K loan.  But there really isn't a tax impact on the principal.

Where there is a difference in tax treatment is with the interest. For a deductible loan(mortgage or HELOC up to 100K or for business purposes) you will only have to earn 450 to pay off the interest. For non-deductible interest(like the 401k) you have to earn 600 to pay off the 450 in interest. However you get to keep that 450 - although it will be taxed again, so you end up with 337.5 on a post tax basis. So the 401K comes out $187 ahead of the HELOC loan. However the HELOC loan would allow you to continue to earn on your 401K balance, which can be a big factor in the long run. However for a short-term loan fees are likely to be a bigger financial impact. Either of these options will look a lot better than Hard Money on a Buy and Hold rental.

I took a 5 year loan against 50% of my 401K to purchase a rental property. I would do this over and over again without hesitation. This was a no fee loan at a rate of 5% which I am repaying to myself. Since there is no mortgage on the rental property I purchased with my 401K loan, I can get a HELOC on the property to keep investing.

Originally posted by @Jesse T. :

A 401k loan is a lot like an upscale "pawn shop".  Usually it is a bad idea, however with a short-term money crunch it can be a very important option.  Your situation does sound like a good use of a 401k loan.

 a pawn shop at 3.25% interest that you pay yourself??

i borowed 50k last year and am very glad i did that. i'd do it again in a heart beat.

Originally posted by @George P. :
Originally posted by @Jesse T.:

A 401k loan is a lot like an upscale "pawn shop".  Usually it is a bad idea, however with a short-term money crunch it can be a very important option.  Your situation does sound like a good use of a 401k loan.

 a pawn shop at 3.25% interest that you pay yourself??

i borowed 50k last year and am very glad i did that. i'd do it again in a heart beat.

It is definitely much better terms than a pawn shop.  The main similarity is it should really only be used as short-term sources of money.  If you have a 5 year plus time frame, the money taken out of the 401K can have a significantly impact on your retirement savings.  The other big risk is leaving your company, which will increase with the longer time frame.

I think the "double tax" aspect of the 401K loans is overstated since it only impacts the interest portion of the payments.

Brian, Dmitriy, and Jim Hitt from American IRA all have the skills and knowledge to you help you. Google them and then pick the company that you feel the most comfortable with.

Also I like the Idea that the performance out paces the taxes or other losses. In the long run if there is a will there is a way.

Since a few asked for a followup, the deal fell through. After seeing the properties, it was obvious the company who flipped them cut quite a few corners. Wasn't worth the risk.  

Poked around some other SFUs for a while before coming across a 4-plex listed about $15k under value with all 4 units rented (3 of 4 are long-term tenants). We made an offer $8k under asking at 8 p.m. Friday and the seller accepted by 10 a.m. Saturday. 3 of the 4 units are rented under market but even still, it has a good cash flow and there is a mostly finished unused attic that could turn one of the 1 br units to a 2-3 br unit so potential for growth. Currently all 4 units rent for $2k/mo. If we brought them up to market it would bring in $2,300 and if we finished the additional space in unit 2, it should bring in about $2,500.  

With the latest, Going to get this one squared away and then see about picking up at least one more this year.