Using 401k Loans To Artificially Raise Annual Contribution Limits Within A PP
Posted: Sat Aug 27, 2011 10:03 pm
Outside of a PP, I don't think this works, because one wouldn't be so "Cash Heavy" in a traditional portfolio. If this trick does work, then it's another check plus for why the PP is awesome.
Background: 401ks are limited to $16.5k in annual personal contribution limit per year, coming out of your payroll through an employer 401k program. Most 401ks allow you to borrow money from the 401k, at around 5% or so, and the money is paid back through payroll deductions over time. i.e. If you borrow $10k from your 401k for 1 year, then you will repay $10,500 back into it, at a rate of 10,500 / # Paychecks Per Year. You pay yourself back the interest. In essence you are lending yourself money at this nominal interest rate.
Traditionally, 401ks loans are considered bad for the following reasons:
1) The interest you pay back into the loan is "post-tax" money, meaning you had to earn money, pay taxes on it, and then use that money to pay the interest. However, once this "interest" you pay yourself goes into the 401k, it becomes reclassified to pre-tax money like the rest of the 401k, and you will have to pay income tax on it when you take distributions.
2) When taking a 401k loan, you lose market exposure. Meaning if you had the $10k in stocks, and took the loan, you no longer have the $10k in stocks. (unless you put the $10k in stocks in a taxable account but then you'd be paying taxes on it as you repay the loan so that's pretty silly).
3) If you terminate employment for any reason, you typically have to repay the entire loan balance in full, within a short time period, or it counts as a nonqualified distribution, and you pay taxes plus penalty. So people who fail at finance and borrow money from 401k to survive will get screwed when they can't pay the loan back if they lose their job.
Now here's why the PP can effectively utilize the 401k loan:
1) We are cash heavy. Thus you can take money from the 401k loan and let it sit in cash in a taxable account. With interest rates low, you are paying almost no taxes anyway, since there are no earnings. If you lose your job, you have the money there and can easily pay it back in full.
2) We can potentially utilize the 401k loan to purchase I or EE bonds, which are equivalently as safe as T-Bills, but with a higher return. The money is locked in for 1 year, making repaying the loan in full impossible if you lose your job, but you might have other liquid assets available to cover that possibility. Since you can't buy I or EE bonds within a 401k, if you are not already maxing out those vehicles, then you can gain by using them with borrowed 401k money.
3) If you trust FDIC HYS, you can put the 401k money into that and get another 1% interest per year. You can't put 401k money into a credit union HYS, but you can put the borrowed loan money into it.
4) You "get" to pay an extra 5% interest to yourself, which means if you have extra cash but already hit annual contribution limits, this is a way to squeeze an extra 5% of your 401k in as a new contribution. As mentioned above, this now becomes pre-tax money so it's not great. However, if you're like me, you have no intention to ever pay taxes on 401k money anyway. I intend to withdraw only enough to stay at $0 tax liability per year. Also I intend to do 401k to Roth IRA conversions in years where I have no income and would otherwise forgo the standard deduction and personal exemption.
It seems as though it might be worthwhile to take a 401k loan, let it sit in a HYS at 1%, and then put back the borrowed amount plus 5% through future payroll deductions. Readjust the rest of your portfolio to maintain 4x25 in whatever vehicles as necessary.
Background: 401ks are limited to $16.5k in annual personal contribution limit per year, coming out of your payroll through an employer 401k program. Most 401ks allow you to borrow money from the 401k, at around 5% or so, and the money is paid back through payroll deductions over time. i.e. If you borrow $10k from your 401k for 1 year, then you will repay $10,500 back into it, at a rate of 10,500 / # Paychecks Per Year. You pay yourself back the interest. In essence you are lending yourself money at this nominal interest rate.
Traditionally, 401ks loans are considered bad for the following reasons:
1) The interest you pay back into the loan is "post-tax" money, meaning you had to earn money, pay taxes on it, and then use that money to pay the interest. However, once this "interest" you pay yourself goes into the 401k, it becomes reclassified to pre-tax money like the rest of the 401k, and you will have to pay income tax on it when you take distributions.
2) When taking a 401k loan, you lose market exposure. Meaning if you had the $10k in stocks, and took the loan, you no longer have the $10k in stocks. (unless you put the $10k in stocks in a taxable account but then you'd be paying taxes on it as you repay the loan so that's pretty silly).
3) If you terminate employment for any reason, you typically have to repay the entire loan balance in full, within a short time period, or it counts as a nonqualified distribution, and you pay taxes plus penalty. So people who fail at finance and borrow money from 401k to survive will get screwed when they can't pay the loan back if they lose their job.
Now here's why the PP can effectively utilize the 401k loan:
1) We are cash heavy. Thus you can take money from the 401k loan and let it sit in cash in a taxable account. With interest rates low, you are paying almost no taxes anyway, since there are no earnings. If you lose your job, you have the money there and can easily pay it back in full.
2) We can potentially utilize the 401k loan to purchase I or EE bonds, which are equivalently as safe as T-Bills, but with a higher return. The money is locked in for 1 year, making repaying the loan in full impossible if you lose your job, but you might have other liquid assets available to cover that possibility. Since you can't buy I or EE bonds within a 401k, if you are not already maxing out those vehicles, then you can gain by using them with borrowed 401k money.
3) If you trust FDIC HYS, you can put the 401k money into that and get another 1% interest per year. You can't put 401k money into a credit union HYS, but you can put the borrowed loan money into it.
4) You "get" to pay an extra 5% interest to yourself, which means if you have extra cash but already hit annual contribution limits, this is a way to squeeze an extra 5% of your 401k in as a new contribution. As mentioned above, this now becomes pre-tax money so it's not great. However, if you're like me, you have no intention to ever pay taxes on 401k money anyway. I intend to withdraw only enough to stay at $0 tax liability per year. Also I intend to do 401k to Roth IRA conversions in years where I have no income and would otherwise forgo the standard deduction and personal exemption.
It seems as though it might be worthwhile to take a 401k loan, let it sit in a HYS at 1%, and then put back the borrowed amount plus 5% through future payroll deductions. Readjust the rest of your portfolio to maintain 4x25 in whatever vehicles as necessary.