Here's a statement of the obvious: The opinions expressed here are those of the participants, not those of the Mutual Fund Observer. We cannot vouch for the accuracy or appropriateness of any of it, though we do encourage civility and good humor.
Support MFO
Donate through PayPal
When It's Ok To Plunder A 401(k) Before You Retire
It's all kind of silly, isn't it? Less and less employers are offering a match so there is really no point to the IRA rules as long as the taxes are paid. After all if there is no match the best way to borrow from your retirement savings is just to suspend contributions. If the tax bracket doesn't change, the effect is the same as withdrawing the same amount, isn't it?
Reply to @Anna: I believe borrowing from 401k is better than stopping contribution due to reduction in taxable income. However, some employees do not allow contribution until the existing loans are paid off so in that case the is little advantage.
One other benefit of borrowing when the employer allows you continue to contribute is that you can invest borrowed money outside on better investment choices and pay back yourself later with interest accelerating the growth of your 401k. Yes that interest is after tax money and will be double taxed when withdrawing money but at today's low interest environment it might be acceptable if you have better choices outside.
I think there are two different question here. One is borrowing vs. withdrawing, and the other is withdrawing vs. suspending. I'll assume for the sake of argument that a withdrawal is covered by one of the penalty exceptions (e.g. first home), so that all that one would owe is ordinary taxes on the withdrawal.
To take your question first - suspend vs. withdraw. Yes, in that case, the two situations are the same. If one contributes, say, $400 to a 401K and then withdraws it, then one sees $400 reduction in income (due to the contribution), but also $400 in extra income (due to the withdrawal). These cancel out, and it's as if you didn't contribute at all, i.e. the same effect as suspending. Notice that we didn't even have to assume anything about tax brackets here.
But borrowing comes out better than withdrawing (or suspending, which we've just seen, is equivalent to withdrawing). That's because you have the ability to put borrowed money back into a sheltered account. You lose that ability if you withdraw money.
If you withdraw money, then you pay taxes on it, say 25%. So if you withdraw $400, you pay $100 in taxes and have $300 to use. When you pay yourself back, you've got $300 in a taxable account. Say that the money doubles by the time you retire. You've got $600, but a tax liability on the gain of $300. You'll owe at least $45 in taxes (15% cap gains rate).
On the other hand, suppose you borrowed $300 (leaving $100 in the 401k). When you pay back the loan, you'll have the original $400 in the 401K. Again, say that the money doubles by the time you retire. The 401K now has $800 in it. You withdraw the money and pay 25% in taxes ($200). You're left with $600. Notice that here we did need to assume same tax bracket in retirement.
[ It turns out that this is the same logic that is used to show that contributing to a Roth is better than contributing pre-tax assuming one maxes out. If one doesn't max out and if tax rates don't change, then pre- and post-tax contributions come out the same. ]
But there are other factors to consider. As the article points out, if you borrow against a 401K and then leave a job, you have to repay the loan quickly, else it is treated as a withdrawal (which could push you into a higher tax bracket, voiding all the calculations above).
Also, I wrote about borrowing against a 401K and not an IRA because one cannot borrow from an IRA. (One can "touch" IRA money for 60 days before returning it as a rollover - even to the same IRA - but I figure that's not the type of "loan" we're talking about here.)
Comments
One other benefit of borrowing when the employer allows you continue to contribute is that you can invest borrowed money outside on better investment choices and pay back yourself later with interest accelerating the growth of your 401k. Yes that interest is after tax money and will be double taxed when withdrawing money but at today's low interest environment it might be acceptable if you have better choices outside.
I think there are two different question here. One is borrowing vs. withdrawing, and the other is withdrawing vs. suspending. I'll assume for the sake of argument that a withdrawal is covered by one of the penalty exceptions (e.g. first home), so that all that one would owe is ordinary taxes on the withdrawal.
To take your question first - suspend vs. withdraw. Yes, in that case, the two situations are the same. If one contributes, say, $400 to a 401K and then withdraws it, then one sees $400 reduction in income (due to the contribution), but also $400 in extra income (due to the withdrawal). These cancel out, and it's as if you didn't contribute at all, i.e. the same effect as suspending. Notice that we didn't even have to assume anything about tax brackets here.
But borrowing comes out better than withdrawing (or suspending, which we've just seen, is equivalent to withdrawing). That's because you have the ability to put borrowed money back into a sheltered account. You lose that ability if you withdraw money.
If you withdraw money, then you pay taxes on it, say 25%. So if you withdraw $400, you pay $100 in taxes and have $300 to use. When you pay yourself back, you've got $300 in a taxable account. Say that the money doubles by the time you retire. You've got $600, but a tax liability on the gain of $300. You'll owe at least $45 in taxes (15% cap gains rate).
On the other hand, suppose you borrowed $300 (leaving $100 in the 401k). When you pay back the loan, you'll have the original $400 in the 401K. Again, say that the money doubles by the time you retire. The 401K now has $800 in it. You withdraw the money and pay 25% in taxes ($200). You're left with $600. Notice that here we did need to assume same tax bracket in retirement.
[ It turns out that this is the same logic that is used to show that contributing to a Roth is better than contributing pre-tax assuming one maxes out. If one doesn't max out and if tax rates don't change, then pre- and post-tax contributions come out the same. ]
But there are other factors to consider. As the article points out, if you borrow against a 401K and then leave a job, you have to repay the loan quickly, else it is treated as a withdrawal (which could push you into a higher tax bracket, voiding all the calculations above).
Also, I wrote about borrowing against a 401K and not an IRA because one cannot borrow from an IRA. (One can "touch" IRA money for 60 days before returning it as a rollover - even to the same IRA - but I figure that's not the type of "loan" we're talking about here.)