Self-Financing Alternative: Borrowing against a 401(k)
Pinto, Jo Ann M., The CPA Journal
Conventional wisdom holds that investors should never tap into their retirement funds until they actually retire. Nevertheless, a confluence of recent events-stubbornly low interest rates, volatile equity markets, and mortgage interest rates that haven't fallen with rates on savings vehicles-suggest that this long-held belief needs to be reexamined.
2000, 2001, and 2002 were not good years for investors. During 2000, the Dow Jones Industrial Average lost 5.02% of its value, the Standard & Poor 500 Index fell 9.10%, and the Nasdaq plunged 39.17%. 2001 was not much better; these indices fell 5.39%, 11.89%, and 20.82%, respectively, for the year. In 2002, the DJIA closed down 16.8% for the year, while the S&P500 lost 23.4% and the Nasdaq lost 31.5%. Savers taking refuge in more conservative investments have also faced paltry returns, as interest rates have fallen on CDs and Treasury Bills. To make matters worse, the cost of servicing mortgage debt has not declined as rapidly as one would expect given other economic indicators.
Ironically, now may be the time to put retirement assets to alternative uses. Specifically, now may be the time to borrow against retirement assets. Emphasis on the word "borrow"; the tax bite, which can be as high as 50% when considering federal, state, and local income taxes and penalties associated with early withdrawals from IRAs and 401(ks, means that withdrawals should still be near the bottom of the list of options for securing funds, right above paying a visit to a loan shark.
Consider the case of Mr. Green, which illustrates the potential benefits of borrowing against a 401(k) account. (It should be noted that borrowing against IRA assets is not permitted under current tax law.) Green, a professional in his mid-forties, is in the process of acquiring a vacation condominium. The purchase price of the condo is $90,000; Green is sinking $27,000 of his personal savings into the unit, along with. a $15,000 gift he received from his parents. Therefore, he needs financing to cover the remaining $48,000. Green considered two financing alternatives: a conventional, 30-year fixed rate mortgage and, at the suggestion of the author, a loan from his 401(k) balance. At first Green was reluctant to consider the second case; an employee benefits counselor in his human resources department warned him that he would not be able to deduct the interest on his income tax return.
A 30-year fixed rate mortgage, with no points, was carrying an interest rate of 5.75% during February 2003. Green would also incur closing costs (including an application fee, an underwriting fee, and a tax service fee) of approximately $1,800 with the mortgage loan. As his HR representative correctly pointed out, his mortgage interest payments would be tax deductible.
Green's 401(k) plan allowed for two types of loans: a primary residence mortgage loan and a general-purpose loan. Both loans were limited to 50% of his vested balance. Because he was not obtaining financing for his principal residence, Green had to apply for a general-purpose loan. The plan required that the loan be repaid within 54 months; it carried an interest rate of 6.25%. Interest payments are not tax deductible, but they are credited directly to his 401(k) balance. In essence, Green would be paying interest to himself. Finally, the loan acquisition costs were trivial: a $25 application fee.
Green and his wife had approximately $180,000 in various retirement savings accounts. These funds were invested in a diversified portfolio of equity, bond, and fixed income funds. Green, a self described risk-averse investor, moved about half his portfolio into a fixedincome fund during August 2001. While the return was only 4.8%, Green thought it was superior to absorbing double-digit losses.
Because choosing the right alternative is a complex decision, involving interest rates, tax deductions, cash flow issues, and the opportunity cost of utilizing retirement funds, the author conducted several what-if analyses, discussed below. …