Pay Down 401k Loan vs Mega Backdoor Roth

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Topic Author
broodeasy
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Joined: Fri May 26, 2017 12:33 pm

Pay Down 401k Loan vs Mega Backdoor Roth

Post by broodeasy »

Hi Bogleheads,

I have a decision to make and I'm not sure what the best course of action is for me at this point. I would like to get your thoughts on how you would approach my scenario. Thank you in advance!

Here is the short version of my situation, some assumptions, and the choices. I have an extra $1200 a month in my budget that I would like to allocate to my 401k. Which course of action do you feel makes the most sense?
  1. Pay down my 401k loan with the extra funds
  2. Contribute after-tax to the 401k and later convert to roth
  3. Something else??
Assumptions:
  • I'm currently maxing the pre-tax portion of my 401k
  • I'm currently maxing my roth and a spousal roth
  • I currently have a large loan with my 401k
  • My plan allows after-tax contributions
  • I don't have an HSA available or any other pre-tax vehicle that I'm aware of
  • I have an emergency fund in place in case of unexpected job loss
  • Only other debt is mortgage
Extra background:

I took out a 50k 401k loan about 1 1/2 years ago to generate a slightly higher return for some of my bond allocation. After taking out the loan I rebalanced out of bonds to account for the loan. I put the money in Ally earning 1% and the loan has a 4.25% interest rate with a $24 a year fee. The original plan was to pay the minimum I could for five years to maximize the amount of interest I pay. I still have all of the cash and can pay it off at any time.

As my 401k plan allows post-tax contributions and in-service distributions I am very inclined to contribute the $300 a week as an after tax contribution. Then in December convert whatever the balance is over to my Roth 401k. However, there is a part of me that is, for some reason, uncomfortable with the idea of maintaining a big loan balance while contributing post-tax with funds that could be used to reduce the balance. It just feels a bit wrong. And yet mathematically I don't think it is. So, what would you do?

Thank you again for your time!
LeeMKE
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by LeeMKE »

401K loans are immediately due and payable upon lots of things out of your control:
loss of job,
change of 401K offering by employer, etc.

I'd pay off the 401K loan and not mess around with that source of funds.
The mightiest Oak is just a nut who stayed the course.
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archbish99
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by archbish99 »

A 401k loan represents two things at once. It's a bond investment inside your 401k, and it's a non-deductible loan outside your 401k. It's only worthwhile if both of those are things you would do anyway. I get wanting to use the 401k interest as a way to boost your bond "returns," but what you're really doing is lowering them overall. Outside the 401k, you're borrowing money at 4.25% (plus a bit for the fees) to invest it at 1%. That just doesn't pan out, even though it enables you to make minor extra contributions in the form of interest. It makes sense if you're doing it to avoid taking a loan with a comparable or higher interest rate.

If you want to make extra contributions, do it with after-tax contributions, not with a 401k loan. I'd pay off the loan.
I'm not a financial advisor, I just play one on the Internet.
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Earl Lemongrab
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by Earl Lemongrab »

LeeMKE wrote:401K loans are immediately due and payable upon lots of things out of your control:
loss of job,
change of 401K offering by employer, etc.
There is no law requiring that and while most employers do, some don't require short-term repayment.

Mega Backdoor is so powerful that I would definitely take the small risk on that.
Two Headed Mule
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by Two Headed Mule »

Mathematically (and leaving aside other considerations like separation from employer, etc.), paying off the loan and making the mega roth contribution are quite similar. You "own" a certain fraction of your traditional 401(k) and the government "owns" the rest (equal to your withdrawal tax rate in retirement). If your retirement tax rate is 20%, for example, then 80% of each payment on the 401(k) loan is effectively a roth contribution, as opposed to 100% of a contribution to the mega roth. The difference in options, then, comes down to the 20% government share, which with the 401(k) loan outstanding the government is effectively lending to you at 4.25%. Since that's probably higher than you can get otherwise, paying off the loan is likely to be marginally better.

Mule
ERISA Stone
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by ERISA Stone »

Check your loan program for the 401k plan. A lot are written so that you either have to make the pre-arranged payment or pay the loan in full. There isn't always an option to pay down the loan if it's not in full.
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jimb_fromATL
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by jimb_fromATL »

broodeasy wrote: I took out a 50k 401k loan about 1 1/2 years ago to generate a slightly higher return for some of my bond allocation. After taking out the loan I rebalanced out of bonds to account for the loan. I put the money in Ally earning 1% and the loan has a 4.25% interest rate with a $24 a year fee. The original plan was to pay the minimum I could for five years to maximize the amount of interest I pay. I still have all of the cash and can pay it off at any time.

:confused I'm having a really hard time seeing how you can come out ahead by taking money out of your 401(k) and investing it at 1% to pay it back at 4.25%. Looks to me like you won't earn enough in the 1% account to pay make all the payments, and thus will have to make up the loss out of your own pocket.

Can you give us some actual numbers to demonstrate how you're coming out ahead? ... especially considering that you could have been earning way over 10% in something as simple as the S&P 500 index in the last year and a half?

jimb
retiredjg
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by retiredjg »

I would pay off the loan.
Topic Author
broodeasy
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Joined: Fri May 26, 2017 12:33 pm

Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by broodeasy »

Thank you everyone for your replies. Seems the consensus is to accelerate the loan with the extra cash flow. Another option for me is to pay off the loan entirely, still contribute the extra funds to the 401k as post-tax contributions and re-evaluate taking out a loan again at a presumably higher interest rate in 6 months. I believe that is the restriction time period on my 401k for loans.

jimb_fromATL wrote: :confused I'm having a really hard time seeing how you can come out ahead by taking money out of your 401(k) and investing it at 1% to pay it back at 4.25%. Looks to me like you won't earn enough in the 1% account to pay make all the payments, and thus will have to make up the loss out of your own pocket.

Can you give us some actual numbers to demonstrate how you're coming out ahead? ... especially considering that you could have been earning way over 10% in something as simple as the S&P 500 index in the last year and a half?

jimb
To answer this question a bit of background is needed. The year before getting the loan I filled all 52k of the 401k with a mix of contributions, match and post-tax contributions. The loan was an idea to get slightly above the overall contribution limit by borrowing against the 401k, still filling it entirely and then on top of that paying the interest for the loan back to the account. This year I'm likely not going to be able to fill it which makes the loan less attractive and not very useful for my original purposes. So paying it off entirely probably makes the most sense at this point for me.

I'm not sure the best way to lay out the numbers, but I'll take a shot at it with big round ones that are made up for illustrative purposes.

No Loan:

401k starting balance (bond portion) on 1/1/2016: $100,000
Bond fund yields 2%: $2,000
401k ending balance on 12/31/2016: $102,000

With Loan:

401k starting balance on 1/1/2016: $50,000
Loan balance on 1/1/2016: $50,000
Bond fund yields 2%: $1,000
Loan interest 4.25%: $2,125.00
Ally savings yields 1%: $500
MINUS Annual Loan fee: -$24

Now let's say I pay back the loan entirely on 12/31/2016 the ending balance would be: $103,101. So we got an extra $1100 into the account and made $500 in taxable ignoring taxes.

Also I agree that I would have done better moving more of the asset allocation over to the S&P 500 but that wasn't something I was looking to do.

Thanks all for the time. I appreciate the feedback!
Two Headed Mule
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Location: Brooklyn, New York

Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by Two Headed Mule »

broodeasy wrote:

No Loan:

401k starting balance (bond portion) on 1/1/2016: $100,000
Bond fund yields 2%: $2,000
401k ending balance on 12/31/2016: $102,000

With Loan:

401k starting balance on 1/1/2016: $50,000
Loan balance on 1/1/2016: $50,000
Bond fund yields 2%: $1,000
Loan interest 4.25%: $2,125.00
Ally savings yields 1%: $500
MINUS Annual Loan fee: -$24

Now let's say I pay back the loan entirely on 12/31/2016 the ending balance would be: $103,101. So we got an extra $1100 into the account and made $500 in taxable ignoring taxes.
You got an extra $1100 into the account. But as noted earlier, you don't own all of the account. You own 1 minus your retirement tax rate. Suppose that's 30%, so that you own 70%. So you have increased your effective roth space by $770.

But there is a cost. You are poorer by around $524 (equal to the forgone higher interest rate in the 401(k) to invest in the lower Ally account, plus the loan fee). Increasing roth space by $770 at a cost of $524 is very, very expensive. It's even worse in your situation because you aren't maxing out the mega roth. The interest expense that you are sharing with the government on the 401(k) loan could instead go into the mega roth and be 100% yours.

Mule
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jimb_fromATL
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by jimb_fromATL »

broodeasy wrote: No Loan:

401k starting balance (bond portion) on 1/1/2016: $100,000
Bond fund yields 2%: $2,000
401k ending balance on 12/31/2016: $102,000

With Loan:

401k starting balance on 1/1/2016: $50,000
Loan balance on 1/1/2016: $50,000
Bond fund yields 2%: $1,000
Loan interest 4.25%: $2,125.00
Ally savings yields 1%: $500
MINUS Annual Loan fee: -$24

Now let's say I pay back the loan entirely on 12/31/2016 the ending balance would be: $103,101. So we got an extra $1100 into the account and made $500 in taxable ignoring taxes.

Also I agree that I would have done better moving more of the asset allocation over to the S&P 500 but that wasn't something I was looking to do.

Thanks all for the time. I appreciate the feedback!
You're not allowing for the amortization of the monthly payments, so your numbers are not quite right, but I think they do illustrate the discrepancy in your logic:
  • The $50,000 at 2% in the 401(k) would have earned $1,000 if you had left it there.
    If you take it out and invest it at 1% it will only earn $500.
    Ignoring the amortization schedule, you would pay back $2125 interest on the loan for a year.
You've earned $500 interest on the $50K, so you have $50,500. But you have to pay back $52,125.
Where do you think the extra $1625 comes from?

jimb
Finance-MD
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by Finance-MD »

Two Headed Mule wrote:
broodeasy wrote:

No Loan:

401k starting balance (bond portion) on 1/1/2016: $100,000
Bond fund yields 2%: $2,000
401k ending balance on 12/31/2016: $102,000

With Loan:

401k starting balance on 1/1/2016: $50,000
Loan balance on 1/1/2016: $50,000
Bond fund yields 2%: $1,000
Loan interest 4.25%: $2,125.00
Ally savings yields 1%: $500
MINUS Annual Loan fee: -$24

Now let's say I pay back the loan entirely on 12/31/2016 the ending balance would be: $103,101. So we got an extra $1100 into the account and made $500 in taxable ignoring taxes.
You got an extra $1100 into the account. But as noted earlier, you don't own all of the account. You own 1 minus your retirement tax rate. Suppose that's 30%, so that you own 70%. So you have increased your effective roth space by $770.

But there is a cost. You are poorer by around $524 (equal to the forgone higher interest rate in the 401(k) to invest in the lower Ally account, plus the loan fee). Increasing roth space by $770 at a cost of $524 is very, very expensive. It's even worse in your situation because you aren't maxing out the mega roth. The interest expense that you are sharing with the government on the 401(k) loan could instead go into the mega roth and be 100% yours.

Mule
With the loan, you're getting more inside the 401k which is great. But it's coming from money that you have already been taxed on. It then gets into the 401k and will grow tax free but will require paying tax on the withdrawal. That money is getting taxed twice. The 1% you are earning at Ally will also be considered taxable income and will be taxed. you're far better off taking that extra money you put in to pay the loan interest and just investing that separately. Ideally it goes somewhere tax protected post tax (e.g. Roth or mega backdoor Roth). If no more room, just invest in taxable. The tax deferred growth benefit only adds about 1%-2% to your Annualized return in comparison to a taxable account. This is substantially cheaper than paying taxes twice on the same dollar.
Topic Author
broodeasy
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Joined: Fri May 26, 2017 12:33 pm

Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by broodeasy »

I just wanted to follow-up with my actions since I find that nice to read for thread closure.

Yesterday I initiated the ACH out of ally and today I contacted HR to figure out what steps I need to do to pay back the loan in full. Then I will leave loans behind and contribute post-tax with the extra funds.

Thank you very much to everyone who responded and especially to Mule for presenting a framework of thinking about a 401k that I haven't thought of before. Also JimB I realize I misunderstood your question and yes, you are correct that the extra funds had to come out of my own pocket. I wasn't comfortable investing the loan principle in such a way that it could lose value and find myself on the hook for the loan payments without the funds set aside to make said payments. So I chose to go with an account that was FDIC insured against loss. Knowing that the spread in interest rates would come out of cash flow or other savings.
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neurosphere
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Re: Pay Down 401k Loan vs Mega Backdoor Roth

Post by neurosphere »

Finance-MD wrote: With the loan, you're getting more inside the 401k which is great. But it's coming from money that you have already been taxed on. It then gets into the 401k and will grow tax free but will require paying tax on the withdrawal. That money is getting taxed twice. The 1% you are earning at Ally will also be considered taxable income and will be taxed. you're far better off taking that extra money you put in to pay the loan interest and just investing that separately. Ideally it goes somewhere tax protected post tax (e.g. Roth or mega backdoor Roth). If no more room, just invest in taxable. The tax deferred growth benefit only adds about 1%-2% to your Annualized return in comparison to a taxable account. This is substantially cheaper than paying taxes twice on the same dollar.
I think that it's a myth about 401k loans being taxed twice. Or rather, it is possibly true that the interest is taxed twice (depending on how you define "twice"). But when comparing two loans with the same interest rate (one loan from the 401k and another conventional loan) the net effect is that the tax paid works out the same. This is because you have to pay the interest on the non-401k loan with after-tax money anyway.

The most common follow-up response to what I just wrote is that one will have to pay tax upon withdrawal of the interest paid to the 401k. So isn't that an "extra" tax too? Yes, but...

Suppose the 401k is entirely invested in a 5% bond. And the interest on the 401k loan is 5%. You will lose 5% in gains from taking a loan (because it's not invested), but "make" 5% on the loan interest, so the net effect is the same income and thus same tax upon withdrawal. So while, yes, you are taxed on the interest on the loan, it is simply because you are "choosing" an "investment" within the 401k with a guaranteed return of whatever the interest rate is (as opposed to paying tax on any other underlying investment gain). Either way, any gains on the borrowed amount (whether taken as a loan, or never actually borrowed at all) are taxable. So the semantics get confusing about the "number" of times something is taxed. But financially, there really isn't an "extra" tax on money borrowed from a 401k vs money borrowed from another source*.

Anyway, that's about as much explanation as I can give. Do a search on this site for double tax and 401k loan, and be prepared to read for hours. :D

[Edited to add: in the context of this thread, the concept of "extra" tax on the 401k loan interest or the "double" taxation is certainly relevant, because the alternative to the 401k loan is not another loan, but rather investing.]

NS

*This assumes the money borrowed from another source is not otherwise potentially tax-deductible, e.g. mortgage, student loans, etc.
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