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!
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.
@Brandon Hall undefined I would like to ask 2 options that I looked at:
1. $50k 401k loan (29% taxes so $14,500 hit; I will just ignore the interest rate for simplified measures)
2. $50k HELOC at 4% interest only; only fee was $75 yearly fee (no origination fees or any other misc fees). $1333 interest + $75 fee = $1408.
loan was over 8 months.
I'm 100% sure the latter would make the most financial sense. I used the funds to do a flip.
just goes to show people are going to believe what they are going to believe.
this is about as clear of an example as I can give to the crowd; again, not trying to say "I'm right" - just trying to (desperately and pleading with people) to try other funding measures as to not get taken to the CLEANERS!
@Scott W. - I think the confusion is coming in at the fed and state tax you are including. You are not taxed on a 401K loan. The money you receive from the 401K Loan is not taxed at all by either fed or state.
If you were to withdraw that same amount of money before you hit retirement age then you will be hit with Fed, State, and penalties for early withdrawal.
I took out a 50K loan from 401K with zero tax implications.
I think the payback everyone is looking at, pre-tax versus post-tax dollars is over analyzing a fairly simple transaction.
@David Teague the point that 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.
We have all agreed on this point, but my point and many others in this thread has been that it doesn't matter. The fact is no matter what kind of loan you take out you are paying it back with after-tax dollars.
The only way that you would lose the benefit of your principal growing tax free is if you had to pay tax on the principal before you returned it to your 401k. So in my example of having a 100k balance, taking out a 20k loan. If you had to payback the 20k but cut a check to the government for 3k (15% eff tax) and now your 401k balance was only 97k, then yes, you would lose 3k of principal. But this is not the case.
@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!
Scott, you will not have to pay any taxes on a 401k loan, only on a distribution. You borrow 20k you pay back 20k (plus interest) and your 401k balance is the same as it was before the loan.
Imagine if you took out a loan in the morning but paid it back the same day with the loan proceeds. You might pay one day of interest, but your 401k balance is the same in the evening as it was in the morning.
Notice, I never took a side. Reason being, blanket rules don't apply to everyone, especially in a 401(k) loan scenario.
It's true that you will pay back your 401(k) loan with post-tax dollars. However, it's also true that you pay back any loan with post-tax dollars.
The benefit a 401(k) loan brings to the table is that it allows you to buy assets with pre-tax dollars and slowly return that money to the 401(k) in the form of after-tax dollars. And yes, that is a benefit.
Consider: you need a $20k down payment. You can take a $20k 401(k) loan or earn the $20k. If you instead elect to save the $20k via your earnings, you really need to earn $28.2k (29% tax rate) in order to save $20k post-tax dollars.
And since it's tax season and I don't have a ton of time to drum up different scenarios, check out the Fed Reserve Sect 3.2 on the issue:
"What about the charge that loan payments are “double-taxed”, once upon repayment and again upon withdrawal in retirement? This turns out to be a mirage: the loan principal is clearly taxed only once—when it is repaid with after-tax dollars. Since loan proceeds are not taxed when distributed, the tax on repayment is really just a delayed tax on the consumption of the loan proceeds. The “second” tax, upon withdrawal in retirement, is tax on the consumption of the repayments in retirement. Thus each dollar of consumption is taxed just once.
Loan interest payments, on the other hand, can indeed be considered double-taxed under traditional consumption tax principles—since interest payments are like new contributions, they should be made with pre-tax dollars and then taxed upon withdrawal. In practice, however, the double-taxation of loan interest relative to a consumption tax is offset by the break borrowers get on the timing of their tax payments: recall that rather than paying taxes on loan proceeds when they are distributed (i.e., consumed), borrowers pay the taxes gradually over the following five years as they repay the loan with after-tax dollars. The time value of these delayed tax payments offsets the double taxation of interest—perfectly so, if the discount rate is the pre-tax rate of return; only partially if the discount rate is lower."
I think some are getting confused by the pre-tax / post-tax issue. I think it would really help to put another quick example out there:
Say you borrow $50,000 from your 401k for 1 day and the interest is negligible. You pay back the loan the next day for $50,001 ($1 interest). There are no tax hits for this loan. The act of borrowing out of your 401k doesn't trigger a tax event.
The real impact of taking a 401k loan is long term oriented. This is the opportunity cost of the investment that you could have made in your 401k, the value of the tax deductability of interest, the growth of tax deferred gains, etc. Short term loans can be viable to use for project financing, but low interest loans with limited closing costs are much more preferred if you can get them.
Notice, I never took a side. Reason being, blanket rules don't apply to everyone, especially in a 401(k) loan scenario.
It's true that you will pay back your 401(k) loan with post-tax dollars. However, it's also true that you pay back any loan with post-tax dollars.
Thank you for your response @Brandon Hall. You confirmed the point some of us have been trying to make; that any loan you pay back is with post-tax dollars.
To take it further if I take a loan from a bank, the proceeds of the loan are also tax-free to me (I do not pay taxes upon distribution of the loan) but I pay it back with after-tax dollars, same difference.
The point is you do not take a huge hit with a 401k loan, it is no different than any other loan except for the short term opportunity cost of earnings (or loss). Therefore not "a danger."
I have to side with David on this one. You can make an argument that you are being double taxed on the interest you pay back but not the principle. And I have read that the double tax on the interest is probably moot as well. Bottom line, the cost is not nearly as high as Scott and Brian are arguing because it completely ignores the fact that you have the original amount of pretax dollars to begin with. Unless you blew it on something stupid but I don't think anyone here is suggesting you should do that.
So, if you took a $10k loan and did nothing with it for a year and then paid it back with the same money, you are not paying back the principle with post tax dollars but rather with the original pre tax dollars. Rather if they let you pay back the loan with pre tax dollars as Scott is suggesting then you would be getting a double tax break on the loan since you were given the money, which you didn't pay taxes on, and you get to pay it back with money that you didn't pay taxes on.
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.
That sounds great. I mistook the OPs 4% fee for procuring the loan rather than the interest rate. My apologies. My local credit union offers them and they state they may charge(these closing costs may include title insurance, appraisal fee and survey costs)
I do know that if I for some reason can't make the payments on the HELOC or the 401K loan the difference in outcomes will be different. In one case the outcome could be foreclosure on my primary residence where as the other offers a big tax hit payable to the IRS.
I don't see anybody talking about should you lose your job don't you have to repay the 401(k) loan within 60 days. To me that seems like a huge disadvantage and could calls for desperate actions to pay the loan back quickly.
@Marcus Johnson this is true, however, I'm sure most of the people have enough $ in the bank. plus, they are trying to invest to buffer - for the future - in case they ever lose a job. :)
@David Teagueundefined I guess the issue here is do you have to pay fed/state taxes on the principal amount on a 401k loan versus NOT having to on a bank loan, HML, etc. it doesn't appear that you do but some people on here are claiming you do.
I don't really know the real answer. this topic really needs one of those BP postings by a CPA and 401k provider.
Job loss is certainly something to consider for a typical 401k. For a Solo 401k, the plan participant is self-employed and that particular risk doesn't come into play. The borrower's continued ability to repay should be considered before taking any loan, though.
@Scott W. here is a really good article from Investopedia about 401k loans. There is even a section called "addressing two myths", the first is called "tax inefficiency" and discusses exactly what we have been talking about here. Hope it helps.
I beg to differ, most people don't have 20k to 50k as a cash cushion when investing in real estate. Plus, why in the world would someone take a large loan from their 401k, when they would miss out on it's potential to grow, if they had a large cash cushion. To risky.
Again, I completely disagree that investors on this forum all have a large cushion such as 20k to 50k that is specifically set aside for Emergencies. Some of us may not 20k to 50k in savings and might have only 10k set aside and have income that could pay the mortgage and expenses should things go sour. Let's query how many posts deal with no money down, investing with little down due to no money, I only have 10k in cash what are my options, etc.....
well, for starters, one should have 3-6 months of an emergency fund just for your personal stuff; and what if stuff goes wrong on your real estate (especially for the newbs who - majority wise - lose $ on their 1st deal)? I'm all for investing but you've got to figure in something so you don't lose your shirt.
I guess you could consider your 401k as a worse case scenario emergency fund.
and those who are posting about no $ down deals, etc on here - well, that's the exeption rather than the normal.
perhaps @jon holdman can chime in on this subject.
I have a 401k loan and a HELOC. (Both for investments).
The 401k loan payments are made post-tax.
The HELOC payments are made post-tax. (My heloc is P&I).
There is no difference.
If you have some source of non-taxed money to pay off loans, it may not be wise to make that public.
There is one drawback to the 401k loan that has not been mentioned.
I recently bought a 4 plex. The underwriters would not let me use the $150k+ I still have in the 401k as "reserves" because I have a loan of $35k. It ended up being not a big deal. But, would have made things easier in underwriting if I had those reserves.
@Michael gob are you saying that the 401k loan PRINCIPAL is not taxed at the fed/state level out of your paycheck? interesting you have a P&I heloc; I have only heard of interest only ones (which I have).
My Earned Income from working for my employer is taxed. The 401k payment is made after my earned income is taxed. The 401k loan itself is not taxed at all.
I have a 401k loan and a HELOC. (Both for investments).
The 401k loan payments are made post-tax.
The HELOC payments are made post-tax. (My heloc is P&I).
There is no difference.
If you have some source of non-taxed money to pay off loans, it may not be wise to make that public.
There is one drawback to the 401k loan that has not been mentioned.
I recently bought a 4 plex. The underwriters would not let me use the $150k+ I still have in the 401k as "reserves" because I have a loan of $35k. It ended up being not a big deal. But, would have made things easier in underwriting if I had those reserves.
Good point Michael, when you apply for a mortgage they usually dig through the last few months of your bank accounts and ask you to explain any large nonemployer deposits. Telling them a deposit is from a 401k loan (or any other loan) will typically disqualify those funds from being counted as reserves.
That can disqualify the funds as well.
In this case, the 401k loan was a couple years old.
The underwriters request a copy of your company's 401k plan policy for a full review. Based on the policy, I was not currently eligible for any additional 401k loans.
If you are eligible for a 401k loan you can use the amount you are eligible as reserves