Right before 4/15, a guy in my office took out a $5k loan from his 401k and put it into a traditional IRA. He got a $5k write off and is forcing himself to put some more money away through the loan payments. I can’t see any downside of doing this other than a possible legal one. Thoughts?
Genious! Yet, you had to share it with us on 5/1/13. Fail!
^Just found out today bro. If there are no legal ramifications, I’m taking out $10k next year. $5k for me and $5k for the Mrs.
Let me get this straight–he transferred money from his right pocket to his left, and thinks that he is richer because of it?
True, he does get to take advantage of a deduction today, but he has to pay that loan back within three years or it becomes a taxable (and probably penalized) distribution. The repayment of the loan is NOT deductible.
And he has to pay interest on the loan from Day 1. That will reduce any return that he gets.
And since he’s covered by a retirement plan, it’s probable that his $5,000 contribution to his IRA isn’t deductible anyway, because the income limits are very low for those who have an employee-provided 401k.
The only advantage that I can see to this is that he gets a $1500-ish deduction today, so he can put that to work for him. However, whether this is smart depends on the market return, and given that interest rates are at historical lows and stock values are at historical highs, I seriously doubt the wisdom of this strategy. And remember–the $1500 deduction today is $1500 less of deductions he gets over the next three years.
I think he has wasted a lot of time and money.
I don’t think there is a legal rule against it mainly because I don’t really see the point. Seems like a waste of time and effort, aka +1 to what greenie said.
I guess you can self direct the investments in the IRA vs whatever funds are in the 401k. Still seems kind of dumb to be. Just contribute to the IRA in the first place.
This is a discipline problem, not a tax or investment strategy. If he wants to invest an extra $1666 per year, then he should invest an extra $1666 per year.
Again, he’s also paying 4% interest on the loan. Ergo, his return has been lowered by 4%.
Tax-deductible contributions Your eligibility to deduct contributions to your Traditional IRA depends on your Modified Adjusted Gross Income and whether you have a retirement plan at work. If you are covered by a retirement plan at work During the 2012 tax year:
- Fully deductible if MAGI is less than $58,000 (single) or $92,000 (joint)
- Partially deductible if MAGI is between $58,000 and $68,000 (single) or $92,000 and $112,000 (joint)
- No deduction if MAGI is over $68,000 (single) or $112,000 (joint)
During the 2013 tax year: - Fully deductible if MAGI is less than $59,000 (single) or $95,000 (joint)
- Partially deductible if MAGI is between $59,000 and $69,000 (single) or $95,000 and $115,000 (joint)
- No deduction if MAGI is over $69,000 (single) or $115,000 (joint)
If your spouse is covered by a retirement plan at work During the 2012 tax year, the uncovered spouse: - Fully deductible if MAGI is less than $173,000 (joint)
- Partially deductible if MAGI is between $173,000 and $183,000 (joint)
- No deduction if MAGI is over $183,000
During the 2013 tax year, the uncovered spouse: - Fully deductible if MAGI is less than $178,000 (joint)
- Partially deductible if MAGI is between $178,000 and $188,000 (joint)
- No deduction if MAGI is over $188,000
To learn more about MAGI, read the IRS Publication 590 (PDF)* or consult your tax advisor.
Not sure about other 401k plans but for ours, he’s paying 4% interest to himself.
Or withdraw the funds from the 401k (subject to vesting and employer match, of course) and roll them over into an IRA. Again, this is predicated on the assumption that the investment choices are poor in the 401k.
Speaking of–if he “borrows” money from his 401k, then doesn’t pay it back, he may forfeit the employer match. And he may not be able to further contribute (and take advantage of employer match) as long as there is a loan outstanding. This differs between 401k’s, so I can’t be more specific than that.
No deduction if the MAGI is over 68k…
Is there more to this, or can i stop reading?
You can stop there.
Do many AFers have traditional IRAs that they contribute to or just rolled over old 401ks into them?
I have my 401k and a roth IRA. When I left my old job by 401k balance was <5k so I didn’t bother rolling it into an IRA and just rolled it into my new 401k.
The term of a 401k loan varies by provider, as does the interest rate, and who you pay the interest to. Though it’s almost a sure thing you’re paying interest to yourself, some shady plans do actually charge interest.
Some problems with this strategy include lack of cash flow flexibility and repayment in the event he’s terminated. It’s nice he’s forcing himself to pay more into his 401k by making the loan payments, but he should just up his contribution on his own. If he finds that he needs an extra hundred or two a month he won’t be able to lower his contribution when it’s a loan payment. And, if he’s fired he’ll almost certainly have to pay back the outstanding amount that year or face penalties and taxes…that sucks either way if you just got fired and needed to hoard cash.
This is a bad plan and this dude should feel bad.
i have two 401ks and a roth. I want to do something with my old 401k, but the management company makes it such a pain to transfer / roll.
Nice!
The kid at my office that did it definitely doesn’t make $68k so it worked for him. The loan was structured for 5 years and the payments are taken out of his paycheck. He’ll have to pay it back in full within 60 days of leaving the company or it will be considered a premature withdrawal. After talking to him some more, he did it because he had a huge tax bill. He’s single and was claiming 9 dependents. It was a way for him to lower his tax bill without coming up with $5k he didn’t have. Sort of ingenious way to do it but doesn’t make up for being an idiot and claiming 9 dependents.
Anyway, this is why I posed the idea on this board, hoping to get all sides of it.
I only put in what my company matches into my 401k and used to put money into IRAs. Stopped funding the IRAs after having kids and now that money goes into 529s. I have a ROTH and my wife has a traditional. Funny thing is I forgot why I set it up like that and it was starting to bother me. Figured it out after seeing the IRS rules I posted. The Mrs. doesn’t work so we got the full tax deduction.
I thought of this years ago, but once I found out that you repay the loan with after-tax dollars I didn’t see any point in doing it. Can’t speak for other 401k plans, but in mine the interest goes to me and me alone.
Do any of you use a financial advisor? I used to look at it as a college professor requesting information from a high school teacher, but i’m starting to consider using one for issues out of my scope.
Oh no. Not this again.
If you’re eligible for a roth, always max that out first. First off, contributions are immediately and always available for withdrawal penalty free. Secondly, you can use roth money to pay for college penatly free. So, aside from feeling good about having a 529 for your kid, there’s really zero reason for doing so until you max out your roth.
Plus, saving for your retirement is more important than paying for your kid’s college. They offer loans for one, not the other.
/end unsolicited financial advice
I thought you could only use the principle invested in a ROTH for college.
Nope, you can use it all. I guess if you really want the state tax deduction then the 529 helps, but that’s the only advantage.
And, if you’re kid decides not to go to college (or somehow goes for free) you get to keep your money for retirement.