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401K loan as a bond proxy


JRM
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I wanted to get some feedback on this idea, mainly to see if there is any risks I'm missing or if I'm thinking about this completely wrong.

 

If your 401k is set up like most there is likely an age-based allocation of stocks and bonds.  The percentage allocation of bonds is increased the closer you are to your planned retirement.  If your bond exposure is anything like the options available in my plan, it is likely earning a very low yield.  Likely 2% or maybe even less due to historically low interest rates. 

 

So how can I get a higher interest rate AND mitigate the interest rate and duration risks?

 

1. Shift 401k to 100% stock allocation

2. Take out a 401k loan for no more than the age-based bond allocation in your 401k. 

 

Let’s say your prescribed age-based bond allocation is 10%.  If you shift your 401k to 100% stock exposure and take out a 401k loan representing 10% of your 401k balance, then you effectively have 90% net stock exposure.

 

What about the 10% bond allocation?  Because a 401k loan is an obligation to yourself, you will pay yourself interest back into your 401k (interest payments are treated as after-tax contributions).

 

For a loan I initiated recently I was quoted an interest rate of 4.25%, which is definitely better than the 2% I was earning otherwise.  I can pay the loan back in equal payments, or early if I choose.  As far as my 401k is concerned, I’ve eliminated the interest rate and duration risk associated with holding a bond fund.

 

Pros:

 

-Low fees ($50 with my plan sponsor to initiate loan)

-No tax or penalties if loan is paid back on time

-Earn higher yield on bond\fixed income allocation in 401k

-Net stock exposure in 401k remains the same

-Access to revolving line of credit

 

Cons:

 

-If you leave your employer you may have to pay back the loan in full immediately

-Automatic paycheck deductions for term of loan

-If unable to pay back loan, the amount will be deducted from 401k; possibly at a time when the market is down (buy high, sell low).

-Loan size is typically limited to the lesser of 50% of 401k balance or $50,000.

 

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I wanted to get some feedback on this idea, mainly to see if there is any risks I'm missing or if I'm thinking about this completely wrong.

 

If your 401k is set up like most there is likely an age-based allocation of stocks and bonds.  The percentage allocation of bonds is increased the closer you are to your planned retirement.  If your bond exposure is anything like the options available in my plan, it is likely earning a very low yield.  Likely 2% or maybe even less due to historically low interest rates. 

 

So how can I get a higher interest rate AND mitigate the interest rate and duration risks?

 

1. Shift 401k to 100% stock allocation

2. Take out a 401k loan for no more than the age-based bond allocation in your 401k. 

 

Let’s say your prescribed age-based bond allocation is 10%.  If you shift your 401k to 100% stock exposure and take out a 401k loan representing 10% of your 401k balance, then you effectively have 90% net stock exposure.

 

What about the 10% bond allocation?  Because a 401k loan is an obligation to yourself, you will pay yourself interest back into your 401k (interest payments are treated as after-tax contributions).

 

For a loan I initiated recently I was quoted an interest rate of 4.25%, which is definitely better than the 2% I was earning otherwise.  I can pay the loan back in equal payments, or early if I choose.  As far as my 401k is concerned, I’ve eliminated the interest rate and duration risk associated with holding a bond fund.

 

Pros:

 

-Low fees ($50 with my plan sponsor to initiate loan)

-No tax or penalties if loan is paid back on time

-Earn higher yield on bond\fixed income allocation in 401k

-Net stock exposure in 401k remains the same

-Access to revolving line of credit

 

Cons:

 

-If you leave your employer you may have to pay back the loan in full immediately

-Automatic paycheck deductions for term of loan

-If unable to pay back loan, the amount will be deducted from 401k; possibly at a time when the market is down (buy high, sell low).

-Loan size is typically limited to the lesser of 50% of 401k balance or $50,000.

 

The cons are as you're paying yourself back, you're paying in after-tax dollars that get double-taxed when withdrawn from the 401k. And since you're the one paying the interest, you're not earning a return - simply moving money you already own in one bucket to another bucket where it will be taxed twice.

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Are there any other loan structures where you are effectively paying interest to yourself?  That seems like an advantage over other loans, even a HELOC that may be tax deductible.

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Are there any other loan structures where you are effectively paying interest to yourself?  That seems like an advantage over other loans, even a HELOC that may be tax deductible.

 

It is an advantage to other forms of borrowing. Low interest that you pay yourself? Way better than higher interest that you pay to others. So it can be a favorable form of financing, but it is NOT a bond proxy or an asset allocation.

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>The issue with the 401k loan is that you cannot contribute to the 401k while you repay the loan.

 

Is this with a particular plan ?

I could always contribute, while I had loan with all my employers in the past.

 

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I wanted to get some feedback on this idea, mainly to see if there is any risks I'm missing or if I'm thinking about this completely wrong.

 

If your 401k is set up like most there is likely an age-based allocation of stocks and bonds.  The percentage allocation of bonds is increased the closer you are to your planned retirement.  If your bond exposure is anything like the options available in my plan, it is likely earning a very low yield.  Likely 2% or maybe even less due to historically low interest rates. 

 

So how can I get a higher interest rate AND mitigate the interest rate and duration risks?

 

1. Shift 401k to 100% stock allocation

2. Take out a 401k loan for no more than the age-based bond allocation in your 401k. 

 

Let’s say your prescribed age-based bond allocation is 10%.  If you shift your 401k to 100% stock exposure and take out a 401k loan representing 10% of your 401k balance, then you effectively have 90% net stock exposure.

 

What about the 10% bond allocation?  Because a 401k loan is an obligation to yourself, you will pay yourself interest back into your 401k (interest payments are treated as after-tax contributions).

 

For a loan I initiated recently I was quoted an interest rate of 4.25%, which is definitely better than the 2% I was earning otherwise.  I can pay the loan back in equal payments, or early if I choose.  As far as my 401k is concerned, I’ve eliminated the interest rate and duration risk associated with holding a bond fund.

 

Pros:

 

-Low fees ($50 with my plan sponsor to initiate loan)

-No tax or penalties if loan is paid back on time

-Earn higher yield on bond\fixed income allocation in 401k

-Net stock exposure in 401k remains the same

-Access to revolving line of credit

 

Cons:

 

-If you leave your employer you may have to pay back the loan in full immediately

-Automatic paycheck deductions for term of loan

-If unable to pay back loan, the amount will be deducted from 401k; possibly at a time when the market is down (buy high, sell low).

-Loan size is typically limited to the lesser of 50% of 401k balance or $50,000.

 

The cons are as you're paying yourself back, you're paying in after-tax dollars that get double-taxed when withdrawn from the 401k. And since you're the one paying the interest, you're not earning a return - simply moving money you already own in one bucket to another bucket where it will be taxed twice.

 

I would say one of the the only exceptions is that if you borrow from the 401k and use that as the down payment for a house, then it might make sense. The house will appreciate over time, and you are using leverage because you are putting down, say 20% for the house, and tax is very friendly for houses.

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Are there any other loan structures where you are effectively paying interest to yourself?  That seems like an advantage over other loans, even a HELOC that may be tax deductible.

 

It is an advantage to other forms of borrowing. Low interest that you pay yourself? Way better than higher interest that you pay to others. So it can be a favorable form of financing, but it is NOT a bond proxy or an asset allocation.

 

Maybe not a bond in a literal sense, but doesn't my 401k see a higher rate of return on the 'fixed income' portion given the numbers I laid out above?  Granted, it's at the expense of something else, I get that.  Its at the expense of my monthly cash flow as some is automatically deferred to paying the loan back.

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Are there any other loan structures where you are effectively paying interest to yourself?  That seems like an advantage over other loans, even a HELOC that may be tax deductible.

 

It is an advantage to other forms of borrowing. Low interest that you pay yourself? Way better than higher interest that you pay to others. So it can be a favorable form of financing, but it is NOT a bond proxy or an asset allocation.

 

Maybe not a bond in a literal sense, but doesn't my 401k see a higher rate of return on the 'fixed income' portion given the numbers I laid out above?  Granted, it's at the expense of something else, I get that.  Its at the expense of my monthly cash flow as some is automatically deferred to paying the loan back.

 

Yes. You're 401k "bucket" sees a higher return. But since you're the one funding that return, some other bucket sees a negative drag. All-in-all, you get 0% return, but you're 401k will look better.

 

I just don't see how that's worth the trade-off of paying taxes on the interest twice to get more money into an account that has limited flexibility on what you can do with the proceeds.

 

Like I said - it is a favorable form of financing. Nothing more. Nothing less.

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TwoCities:

 

Yes. You're 401k "bucket" sees a higher return. But since you're the one funding that return, some other bucket sees a negative drag. All-in-all, you get 0% return, but you're 401k will look better.

 

I just don't see how that's worth the trade-off of paying taxes on the interest twice to get more money into an account that has limited flexibility on what you can do with the proceeds.

 

Like I said - it is a favorable form of financing. Nothing more. Nothing less.

 

I think this mention here of "paying taxes twice" is incorrect...  JRM's assertion is in essense right (with a starting assumption).

 

*IF* you have a bond allocation in your 401(k), then borrowing money out of your 401(k) and repayinig in back with interest over time is in affect the same  but better *if* your interest rate is better than your bond alternative (of course noting the various vagaries of 401(k) loans, forced pay backs, etc). (401k loans should in no way prevent regular contributions to a 401(k)...)

 

You don't pay taxes on the interest *twice* as you suggest, you only pay once. You put pre-tax $$$ into your 401k, and when you loan them out, you don't get taxed on that, and then you put the interest in (you can think of the interest as simply an extra contribution to your 401k) and of course when you retire and withdraw you are taxed on *all* contributions + gains.... yes, you will have more taxes on exist if you model this out, but that is because you effectively stuffed more $$$ into the 401(k)... so I would call that a feature not a bug...

 

But I would say JRM is basically right... again, *if* you are offseting a bond allocation with the loan, i think it's reasonable.  If you aren't offsetting a bond allocation, you have a complex calc of risk, volaitity, and return as likely your 401(k) inivesting will grow faster than your 401(k) loan.

 

Thought experiment:

What if you could have a 401(k) loan which "charged" 20%... would you do it? 

Answer --> You should.. if you don't see the reason why you would, then I think you aren't in a situation where you have absolutely maxed out all tax advantaged contributions and are looking for more ways to stuff $$$ into tax deferred accounts....

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TwoCities:

 

Yes. You're 401k "bucket" sees a higher return. But since you're the one funding that return, some other bucket sees a negative drag. All-in-all, you get 0% return, but you're 401k will look better.

 

I just don't see how that's worth the trade-off of paying taxes on the interest twice to get more money into an account that has limited flexibility on what you can do with the proceeds.

 

Like I said - it is a favorable form of financing. Nothing more. Nothing less.

 

I think this mention here of "paying taxes twice" is incorrect...  JRM's assertion is in essense right (with a starting assumption).

 

*IF* you have a bond allocation in your 401(k), then borrowing money out of your 401(k) and repayinig in back with interest over time is in affect the same  but better *if* your interest rate is better than your bond alternative (of course noting the various vagaries of 401(k) loans, forced pay backs, etc). (401k loans should in no way prevent regular contributions to a 401(k)...)

 

You don't pay taxes on the interest *twice* as you suggest, you only pay once. You put pre-tax $$$ into your 401k, and when you loan them out, you don't get taxed on that, and then you put the interest in (you can think of the interest as simply an extra contribution to your 401k) and of course when you retire and withdraw you are taxed on *all* contributions + gains.... yes, you will have more taxes on exist if you model this out, but that is because you effectively stuffed more $$$ into the 401(k)... so I would call that a feature not a bug...

 

But I would say JRM is basically right... again, *if* you are offseting a bond allocation with the loan, i think it's reasonable.  If you aren't offsetting a bond allocation, you have a complex calc of risk, volaitity, and return as likely your 401(k) inivesting will grow faster than your 401(k) loan.

 

Thought experiment:

What if you could have a 401(k) loan which "charged" 20%... would you do it? 

Answer --> You should.. if you don't see the reason why you would, then I think you aren't in a situation where you have absolutely maxed out all tax advantaged contributions and are looking for more ways to stuff $$$ into tax deferred accounts....

 

When you put money into the 401k it's pretax. When you borrow it, it's not taxable and still pre-tax dollars. But you're paying the interest with post tax dollars - money from your wages or other investments that's already been taxed.

 

Aall of the interest you're paying yourself is post tax. That's not big deal if you're just using this as an alternative to borrow - ALL interest on any borrowing is paid post-tax.

 

But as an "asset allocation alternative" to bonds, you're just paying post-tax dollars into a 401k where you'll pay taxes on those same dollars again as when you pull them out in retirement.

 

Taxed twice.

 

As far as increasing your return - it doesn't. The return is 0%. Yes, you increase the return within the 401k - it's getting 4% instead of 2%. But that money is already yours. It's not a 4% return. It's you taking 4% out of your checking account and putting 4% into your 401k account. +4% in one account and -4% in another. 0% return to you - but one positive return to N account and one negative return to an account. And it's actually worse, since you're taxed twice on that 4%, it's actually a net drag.

 

You can't borrow your way to prosperity - particularly if you're borrowing from yourself.

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I think under the right conditions it can work out better and not just be a drag due to taxes.  Eliminating interest rate risk in the bond allocation is helpful if interest rates rise quickly.  Also, I may have a timely investment opportunity that I am able to better capitalize without the need to sell something else.

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I think under the right conditions it can work out better and not just be a drag due to taxes.  Eliminating interest rate risk in the bond allocation is helpful if interest rates rise quickly.  Also, I may have a timely investment opportunity that I am able to better capitalize without the need to sell something else.

 

You can eliminate the interest rate risk by owning a money market or floating rate bond fund in the 401k instead of owning fixed-rate bonds. Borrowing from yourself at 4% doesn't eliminate interest rate risk - just means you're not marking the loan to yourself to market.

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Got it. The interest is taxed twice. Now I see your view.

 

I think it’s definitely not a road to riches but it makes sense IMO in some cases.

 

2x taxation is only an issue if it is a traditional 401k. With roth 401k, you get taxed once on both the contributions and withdrawals (including the interest paid on the loan). This would be a fine strategy if you have a 100% Roth 401k. This would also work if you only have access to post-tax 401k (yay for 3 different types of 401k). You would also need to do some funny gymnastics:

Day 1 - Switch your entire Roth 401k to a bond fund

Day 2 - (once the transaction settled), take out the loan. Let's say it's 10% of your portfolio.

Day 3 - (once the loan is processed), take the remaining 90% of your bond holdings and convert it back to stock fund.

 

This will ensure that the loan you are taking out is against the bond fund and thus not handicap your stock fund performance.

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