the danger of a 401k loan

Real Estate Deal Analysis & Advice

the danger of a 401k loan

Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes

I'm sure it's been discussed before but I'd like to tell something I see (correct if I'm wrong):

a 401k loan should be among the last resorts for borrowing. reason being is you pay it back AFTER taxes. if you live in Illinois and are in the 25% federal bracket, that's 29%! and it's EVERY time you take a loan.

I did a home equity line of credit at 4% last year. I get to deduct it so the cost of the $ is around 3%? A TON cheaper than the 401k loan. a 401k loan is almost the equivalent of a hard $ loan.

oh, and you don't get to deduct the cost of paying those taxes back on your real estate investment.

IMO, a lot of people don't have a clue about their true cost of borrowing for this vehicle. it's not mentioned on the internet very much either.

there's a guy I know who is an underwriter for a bank and doesn't know about this; I feel bad for people who don't see the true cost of this.

search for private loans, bank loans before this. and make sure you know how much of a hit you will take. for a $50k 401k loan, that's almost $15k you eat!

if I'm wrong, please correct me!

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Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes

What? When you pay back your HELOC you are paying back principal and interest with after tax dollars. You may be able to write off the interest paid if the HELOC is taken out on your primary residence.

When I pay back my SD 401K loan there are 2 costs: 1) opportunity costs for earning income in the 401K tax deferred (if you think the loan will offer a better return then discount this option) 2) The interest you charge yourself cannot be written off vs the HELOC (for a HELOC secured against primary residence).

The cost difference is the interest that cannot be written off but if you have a SD 401K the interest is going back into your account and presumably somebody else is paying that interest because you used the 50K for a down payment on income property.

I'll give you an example: for a 50K loan at 4.25% assuming tax bracket of 32%. The first year interest will be 1947.77 and writing off the interest in a similar HELOC would have allowed you to save 1947.77 *.32 = 623.29. The interest drops off as the loan progresses to year 5 which is a couple hundred bucks.

The cost of a SD 401 K loan through my provider (mysolo401k) was negligible. If you would like to know more of those details reach out to Mark Nolan here on the site.

At the end of the day this is another source of down payment funds which given my situation I believe to be better than a HELOC. My personal reasons: 1) The loan does not show up on your credit report. 2) The interest is going back to my account. 3) It was much cheaper to do and easier than a HELOC to obtain. 4) I thought that this was the highest and best use of these funds as I had the money sitting in a money market fund anyway as I'm a bit timid of the stock and bond market at this time.

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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@Brian Liscio B-I-N-G-O.
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Brian Liscio
Little Falls, NJ · Member since 2014 · 88 posts · 49 votes
10y
Sorry let me fix that last post I'm on a bus. Lol So... If I take out a company 401k loan it gets paid back post taxed directly out of my pay check. If I take out any other type of loan I pay it back with post taxed money from my pay check.
1 Reply
David Teague
Arlington, TX · Member since 2014 · 13 posts · 14 votes
10y
Originally posted by @Scott W.:

@David Teague no, a credit card is not paid back with after tax dollars. just the interest. same with a bank, a HELOC, hard $. just different with a 401k loan. I agree, it appears illogical.
So in order for it to be pretax money I would have to make an above the line deduction. So if I make 100k a year and I spend 90k on credit cards, I only have to pay taxes on 10k of income. That's genius!
1 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@David Teague sorry but you just don't get it. good luck to you though.
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Cory Adams
Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes
10y
What? When you pay back your HELOC you are paying back principal and interest with after tax dollars. You may be able to write off the interest paid if the HELOC is taken out on your primary residence.
When I pay back my SD 401K loan there are 2 costs: 1) opportunity costs for earning income in the 401K tax deferred (if you think the loan will offer a better return then discount this option) 2) The interest you charge yourself cannot be written off vs the HELOC (for a HELOC secured against primary residence).
The cost difference is the interest that cannot be written off but if you have a SD 401K the interest is going back into your account and presumably somebody else is paying that interest because you used the 50K for a down payment on income property.
I'll give you an example: for a 50K loan at 4.25% assuming tax bracket of 32%. The first year interest will be 1947.77 and writing off the interest in a similar HELOC would have allowed you to save 1947.77 *.32 = 623.29. The interest drops off as the loan progresses to year 5 which is a couple hundred bucks.
The cost of a SD 401 K loan through my provider (mysolo401k) was negligible. If you would like to know more of those details reach out to Mark Nolan here on the site.
At the end of the day this is another source of down payment funds which given my situation I believe to be better than a HELOC. My personal reasons: 1) The loan does not show up on your credit report. 2) The interest is going back to my account. 3) It was much cheaper to do and easier than a HELOC to obtain. 4) I thought that this was the highest and best use of these funds as I had the money sitting in a money market fund anyway as I'm a bit timid of the stock and bond market at this time.
7 Reply
Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
10y
@Cory Adams
There is a 3rd cost, which a lot of posters here seem to be missing. That is the loss of tax-deferral on the 401k funds taken out for the loan. You have replaced pre-tax funds in the plan with funds that you have paid taxes on. When you take a distribution from your plan in retirement, you will pay taxes on this money again.
It is not a cost that hits you in the pocket book today, but it is a cost to your overall net worth none the less, and something that needs to be considered before taking a 401k loan.
To put it in simple terms, it is baking-in a loss equivalent to your tax rate on the 401k. it is like selling a stock for $7K and then buying the same stock a week later for $10K.
As you note, sometimes it is OK to take this hit in order to put a big plus on the personal side of the ledger. You just want to be sure there is a big plus.
What I see a ton of is underfunded newbie investors grasping at straws trying to come up with funding for deals and that is why I tagged onto this post by @Scott W. Ready, fire, aim is not a good financial strategy, but it is all too commonly used. And unfortunately, there are plan providers and midnight TV real estate gurus out there that dangle the 401k loan out there as if it were free money - thereby feeding this mindset . It is not free money. Thinking things through end-to-end is key to success in real estate investing.
I challenge anyone here to sit down with a qualified CPA and ask if a 401k loan is a good idea.
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David Teague
Arlington, TX · Member since 2014 · 13 posts · 14 votes
10y
Originally posted by @Brian Eastman:

@Cory Adams
There is a 3rd cost, which a lot of posters here seem to be missing. That is the loss of tax-deferral on the 401k funds taken out for the loan. You have replaced pre-tax funds in the plan with funds that you have paid taxes on.
Let me try and illustrate with two scenarios:
Scenario #1
My 401K has 100k of pre-tax savings. I take out a loan of 20k against my 401k and I pay it back with interest. I now have 100k of pre-tax savings in my 401k.
Scenario #2
My 401k has 100k of pre-tax savings. I take a loan out from a bank of 20k and pay it back with interest. I now have 100k of pre-tax savings in my 401k.
There is no actual difference in your 401k pre-tax savings with either scenario,
This is a simple scenario to illustrate the point. In actuality we would lose any potential earnings (or loss) while we had the loan out. But other than that there is no harm in taking a 401k loan.
1 Reply
Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
10y
@David Teague
Your scenario 1 is incorrect.
When you repay the loan, you have $80K of pre-tax savings and $20K of post-tax savings in the 401k.
The initial $20K was put into the plan with $20K of pre-tax earnings. You then had to earn enough to have $20K of post-tax cash in your pocket to replace that money from the 401k.
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Jason Krick
Investor · Reading, PA · Member since 2014 · 196 posts · 118 votes
10y
So, please critique this scenario. I'm a new investor. My access to funds is limited. I find an REO property in terrible shape. It is listed at $39,900. I negotiate with the bank and get it under contract for $17,500. I take a loan from my 401(k) for $25,000. I buy the house for cash. Repairs to the property and conversion to a 2 unit are $67,000. Add in holding costs, insurance, permits, etc. and I am all-in for $90,000. I find a commercial lender at a local credit union who loves the deal, and sets me up with a construction loan, which will be refinanced into a mortgage at 75% LTV. They will lend me 75% of the appraised renovated value. No seasoning required. It appraises at $50,000 currently and $135,000 after rehab. So, I take a $25,000 loan for approximately 3-5 months, and then my mortgage pays off the construction loan, pays off the 401(k) loan, and puts another $11,000 into my business reserves. I'm now into the property for $0, increased my net worth $45,000 in the property, and another $11,000 in cash. I jump on this deal, which I couldn't normally do, because I am not in a position to put $25,000 down on a deal. Is this situation still a horrible reason to take a loan from my 401(k)?
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@David Teague you can believe whatever you want. We're just here to help anyone who is willing to listen. I don't like to see people taking a bath. People have helped me on here and now I want to do the same.
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Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
10y
@Jason Krick
The situation you describe is a very good return on investment, and something that might justify the use of a 401k loan - if you had no other available source of funding.
The key point here is that you just want to fully understand the numbers first. As evidenced on this thread, there is a lot of mis-information and mis-understanding on this topic. That $25K costs a lot more than just $25K plus whatever the interest to the plan is.
As with @Scott W., I spent a good bit of my time today on this thread, but not because I gain anything from it. If anything, we sell less Solo 401k plans to people who are solely interested in the loan provision. But I'm OK with that. Contributing to investor knowledge is what my business is about, and why I make the effort to participate here on BP.
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Jason Krick
Investor · Reading, PA · Member since 2014 · 196 posts · 118 votes
10y
@Brian Eastman
Thank you. I know my specific situation is not common. I was just getting a bit worried, as it seemed like the best solution, given my situation. Thanks for the info.
I get the overall thoughts and reasoning for this thread. It's a great topic IMO, and should be explored in more depth. I think the point that was made about how you must earn $14k to replace $10k in funds illustrates that stance. Not sure who mentioned it, but it painted a good picture.
Thanks again for your opinion on my current situation.
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Cory Adams
Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes
10y
@Brian Eastman The black art of Economics dictates that one always ask the question "Compared to what?" when considering whether or not to participate in a particular economic transaction.
- Assumptions in my case: The money was going to sit in a MMF earning close to nothing (not my entire account but this 50K).
Let's compare the scenarios with 50K borrowed from a SD 401K vs HELOC:
50K borrowed at 4.25%
Total Interest 5,589
Total Cost with SD 401K:
Loan Setup Fee: $200
Interest 5,589
Total Cost 5,789
Total Cost with HELOC:
Origination Fee (4%) 2,000 (assume 4% includes origination, doc stamps, appraisal)
Interest 5,589
Interest deduction saved at 32% tax bracket = 1788
Total Cost = 5,801
In reality the 5,589 interest goes back to my bottom line returned to the 401K with after tax dollars paid by a renter (in my scenario). The opportunity cost of not doing this deal for me was income I would not have had. Oh and let's not forget that I have the ability to also shield some of the income from the property acquired with this down payment via depreciation against an income stream for 27.5 years.
If the 401K was not SD and company provided it is very likely that the fees would be higher and that the interest would have gone back to the plan provider instead of my account. In that case your concerns are valid as the comparative advantages are diminished.
I challenge any CPA to call themselves qualified if they don't think the above scenario makes economic sense.
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@Cory Adams why are you paying a origination fee on a heloc? I've never paid anythung like that except for a $75 yearly maintenance fee. We will try and get a cpa on here soon (long time coming).
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
Also I didn't pay a dime for the appraisal. The bank did and should in most scenarios (at least in my area they do). & idk where these taxes and stamps are coming from. I didn't pay for anything except for the $75 fee after a year and each year thereafter.
After reading this thread it seems a lot of peopleon bp seem to just wing it.
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Frank Gucciardo
Highland, NY · Member since 2013 · 169 posts · 130 votes
10y
Sorry but I fail to see the logic being proposed here. There is absolutely no difference if I am taking my after tax dollars to pay back a 401k loan or a bank loan. The only risk is opportunity cost by taking those funds out of the stock market.
I am not taxed on the loan when the money comes out of my 401k. Any payment to any loan would be using those after tax dollars. What difference does it make if I'm paying a bank or paying myself... It's a wash.
4 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
the principal is paid back on your 401k loan. Take one put and pay it back and you will see what I mean.
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Frank Gucciardo
Highland, NY · Member since 2013 · 169 posts · 130 votes
10y
I have and it made zero difference. What are you expecting me to have seen?
1 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@ste
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@Steven Hamilton II is there anyway a CPA can answer this question to end this conversation once and for all, please?
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David Teague
Arlington, TX · Member since 2014 · 13 posts · 14 votes
10y
Originally posted by @Brian Eastman:

@David Teague
Your scenario 1 is incorrect.
When you repay the loan, you have $80K of pre-tax savings and $20K of post-tax savings in the 401k.
The initial $20K was put into the plan with $20K of pre-tax earnings. You then had to earn enough to have $20K of post-tax cash in your pocket to replace that money from the 401k.
The fact that I paid back a loan with after-tax dollars has nothing to do with the original balance of my 401k. If my original balance was not tax free (assume 15% effective tax rate), I would only have had 80k in my savings to begin with. But I didn't, I had 100k of tax free savings. Taking a loan against that and paying the loan back with after-tax dollars does not change the fact that I have 100k balance and not an 85k balance. It is no different than taking a loan from any other source and paying it back with after-tax dollars. So if I took out a loan from a bank or a hard money lender or a credit card, I would still have had to earn enough (loan payments x (1+effective tax rate)) to pay back that loan in after-tax dollars. There is no difference.
The proof is in the math. In both my scenarios the balance is the same 100k. It has nothing to do with belief.
1 Reply
Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@Brandon hall is also a CPA. Need one on here to solve the mystery. but I still doubt others on here will believe them. :) again, I hope I am wrong as I could use $50 G's to invest.
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Brandon Hall
CPA · Raleigh, NC · Member since 2013 · 1k+ posts · 2k+ votes
10y
@David Teague the point that @Brian Eastman is trying to make is that when you take a 401(k) loan, you will be paying it back with after tax dollars that your pre-tax loaned dollars are producing.
For instance, you take a $20k loan and invest in real estate. Your $20k principal is pre-tax and that's great, however, it generates income (rent) that is subject to taxation. This money, after tax, is then used to pay off the 401(k) loan. So you are, in effect, replacing your 401(k) pre-tax dollars with after-tax dollars. You are losing the benefit of growing your 401(k) principal tax free.
@Frank Gucciardo the difference is called opportunity cost. It's a real variable that plenty of haphazard investors completely fail to consider, and that's dangerous to the investor's future financial position.
@Scott W. thanks for tagging me.
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Scott W.
OP
Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
10y
@Brandon Hall so, to answer everyone's question here, if I am in the 25% federal & 4% state tax bracket (29% total), and I take out a $20k 401k loan, will I wind up paying $5800 in taxes when I pay it back or $25,800 total with the principal?
that's where the arguments are originating here. :) hopefully you can answer it to clear up the brawl once and for all!
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Frank Gucciardo
Highland, NY · Member since 2013 · 169 posts · 130 votes
10y
@Brandon Hall, thanks for responding here. Completely understand and agree the opportunity cost and that you seriously have to weigh the opportunity you are using the loan for against what you may miss out on in your 401K (ie. dividend payments, upswings, downswings, etc..) is a major factor. I think that is the single biggest factor to consider when taking out the 401K loan.
I still contend that you are going to pay back any loan with after tax dollars, whether it be 401K or a bank loan. That factor is never going to change no matter the source of the loan.
In my case, my 401K loan had no origination fees or costs, was quick to get, does not show on credit report, and is used as a short term bridge loan until I can extract the equity from the house and re-amortize the amount over 15years (instead of 5). Also, I weighed the benefit of getting into the particular property that I'm under contract on versus the short term opportunity cost risk and deemed it to be sufficient to take the funds out of the 401K.
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