401k withdrawal penalty - theoretical question

^Right bchad. I took a loan out of my 401k to buy a beach property that we primarly use as a rental during peak season. At the time, there is no way I would have had the liquidity for that down payment without taking out the loan. It pays more than the mortage annually, so makes total sense. The only reason I wouldn’t have done it is because I wouldn’t want to deal with renters, but my fiance is in sales and likes handling that end of it so it’s all good. You figure, I took out about $65k from my 401k but the place rents for $3500 to $4000 per week 16 weeks of the year and so far has been booked several months in advance. In my opinion, that is when you take a loan from your 401k. I mean, it’s nealy 100% return (in reality closer to 30% net of interest payments) with relative certainty year in, year out.

Why are penalties and taxes part of the discussion when talking about taking a loan from your 401k? Those don’t come into play. Unless…are you talking about the taxes on gains from the hypothetical investment you’re using the proceeds for? That may be overthinking a bit. I don’t think a lot of people take loans from their 401k to make investments. If they do, I need to get in touch with these people. I have a few things I’d like to sell them.

Anyway, while we all know you should only pursue courses of action that have a positive net present value, sometimes personal preference overrules math. In my case, I needed a bit more cash to get to 20% down to avoid PMI. I hate PMI so farking much I was fine with giving up a bit of future compounding. I regret nothing.

It varies by provider. Mine allows you to go up to six.

Not entirely true. If you borrow to buy a home, you’re just subject to the five-year repayment provision. However, you still have to pay loan under some special rules that I don’t fully understand. (In the era of NINJA loans, why would you put money down anyway?)

The IRS says five.

Code Section 72§. Under House bill 11067.

Wow. We really are a bunch of geeks and nerds. We need to play football and get an online girlfriend. Then everyone will think we’re cool!

No one asked me what the loan was for so I’m not sure how that’s enforceable. Also, I chose the term. Just happens to be five years but I could have done anything from 1-6 years. You could very well be right, I’m no tax expert, but I’m not sure how the IRS would know.

Also, the loan terms vary by provider. My terms won’t look like the next guys. Hell, not every provider even allows loans. It’s not uniform in the least.

Edit: Maybe the max term was five. It’s been a couple years. Thought it was six but I’m probably misremembering.

So I just took a look at my 401k and see that I drastically underperformed the S&P in 2012. Back to the chopping block for an improved asset allocation.

@bchad:

“I did forget that Mobius was looking at this as a way to capture the company match and spend it now”

No, that’s not my angle. When you approach the question with the mantra that early withdrawal is bad because you’re getting hit with a tax penalty and are reducing your retirement savings, you are thinking of your contribution as a sunk cost (“why one wouldn’t want to leave it in the 401(k)?”).

Do you max out your contribution limits every year and have you always done so? Perhaps you do. Many people don’t, despite their employer match, because they may lack disposable income at the time and putting money away for retirement doesn’t rank as high on their priority list. By considering the early withdrawal option, what they could be doing is “circulating” money through their 401k and keeping the amount of disposable income they need while fully capturing the company match and realizing net benefit from it. You can keep the extra in your 401k rather than “spend it now” - it’s a net positive any way you look at it.

I beat the S&P last year, but my allocation is constant and long term: 30% US large cap/20% US small cap, 30% international developed/20% emerging.

I suppose if you feel your retirement is overfunded and you’re not likely to live long enough to spend it all, and that you don’t care about heirs inheriting any residual retirement funds after you kick the bucket, then you might want to pull more income into the present while trying to ensure you can capture as much of employer match as possible.

It seems like an unrealistic scenario for most people, though.

EDIT: Oh wait, I get what you’re saying. If you need the disposable income much more in the present, then this is a way to do it while still taking advantage of as much of the employer match as you can. Yes, I can see that. And maybe this does make sense if your income truly is insufficient to survive (like $45k in NYC). Usually, though, there are vesting conditions that get in the way, I’d think.

It’s like anything else. If they ask you about it, you have to provide documentation. If they don’t ask you, then they don’t ask you.

The IRS relies largely on the honor system. I could take a $20,000/year home office deduction every year, and 55 cents per mile (for 50 miles, everyday) to my “part-time job”. It would only become an issue unless I get audited.

A lot of people ask me about IRS compliance. It’s usually some variant of “How do they know? It’s not illegal if you don’t get caught, right?” My answer is: “The speed limit is 70 mph. If you go 80, it’s illegal. You might not get a ticket, but you are still breaking the law.”

(FYI–a home office deduction is one of the best ways to get audited.)

Well, it’s not so much about me trying to get away with anything as lack of knowing in the first place. Since a down payment for a house is one of the most common reasons people take a loan from their 401k you’d think somewhere in the process you’d get notified there are potential tax implications.

Most of the time, people aren’t trying to get away with something. And a lot of the time the IRS doesn’t ask. However, in your case I’m surprised they didn’t. When they see something big, they’ll usually ask.

One example–a few years ago, anybody who bought a house got an $8,000 credit. And every single person who took the credit got a letter from the IRS asking them to substantiate it. They weren’t lying or anything–the IRS just wanted to see some documentation.

I think we may be talking about different things. There was nothing for the IRS to see. There were zero implications to my taxes as a result of the loan and buying the house (aside from a change to my mortgage deduction of course). Unforuntately I didn’t qualify for the new house credit.

There most certainly is something for the IRS to see. Your 401k provider should have sent them a 1099 that said you took a taxable distribution. Let’s say that amount was $20,000, and you are in the 25% bracket. You now owe $5,000 in taxes until you prove otherwise. I’m surprised that they haven’t asked you about it.

In your case, all you have to do (if they ask) is send them a letter along with your settlement statement for the house, and just like you said, there will be no change in your taxes. But the burden of proof is on you that you don’t owe the money.

Remember this–if you come into any money in any way, or have virtually any accession to wealth, you owe taxes on it unless you can prove otherwise.

But a 401k loan in not a taxable event no matter what the proceeds are used for, so what difference does it make if I bought a house or made it rain? As long as I pay it back on schedule there’s no tax liability.

I’m not concerned about my situation. Just curious as to why I would need any documentation relating to a home purchase to justify my 401k loan.

That’s true. We’re talking about those situations where you don’t pay it back within five years. After five years, it’s not a loan anymore. It’s a taxable distribution.

If I were you, I wouldn’t be concerned about your situation either. I thought that you had withdrawn from your 401k. You didn’t–you just took a loan. My mistake.