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Greetings,

Hypothetical question here:

Let's say I am ready to retire because I've reached retirement age and I have accumulated $2,000,000 though participation in my company's 401K plan. The 401K is diversified appropriately for my age and performs very well, generating an 8% average yearly return.

Now, assuming my living expenses for one year in retirement are $100,000, I seem to have two options at retirement age:

1) Withdraw my yearly living expenses from the 401K plan and pay 15% in capital gains taxes when I do.

or,

2) Use the portfolio value as collateral for a $100,000 personal loan from a bank at a mere 6%. I would pay back this loan by transferring this amount in 401K shares to the bank, per the terms of the loan, plus interest.

At the risk of sounding naive, is option 2 possible as stated here, or through some other means? If so, this would seem to be a decent strategy to avoid paying capital gains taxes on 401K withdrawals.

Any comments are greatly appreciated.
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FoolishMiser,

On option 1, capital gains do not apply. All withdrawals are ordinary income.

Although I have never heard of what you propose in option 2, I believe you will still be paying taxes on the withdrawal.

Remember, an IRA, 401K and other qualified plans are somewhat like separate people for taxes. When they pay you, any withdrawal, it is taxable as standard income. The exception is the post-tax contributions. These cannot be targeted for withdrawal and a portion of them are mixed with the taxable withdrawals each year until only taxable remains.

Also, once you reach 70 1/2, RMD's will kick in and you will be forced to withdraw a certain percentage of the balance each year.

Of course, Roth IRA's do not have any of this tax/RMD business.

You can rollover the 401K account to a Traditional IRA without paying tax, but the same basic rules apply to withdrawals. IRS Pub 590 is for IRA's.

You may want to talk with a fee-only planner to get a complete picture about how to best manage this. $300 or $500 spent now can save a lot of problems in the future.

Another thing to consider is the annual expenses and how accurate your number is. I started planning for retirement using almost double what we ended up paying in reality.

Gene
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Gene,

Thanks for this reply. I was unaware of RMD's. This is definitely something to include in the planning. Just a quick look at an online RMD calculator on the internet, it seems that a very low percentage of the 401K balance is required to be withdrawn, only around 3.6 percent in my hypothetical case.

For example, according to one calculator I found, if I had been born in 1945, and my 401K balance reaches $2M in 2015 (when I turn 70 1/2), I would be required to withdraw a minimum of $73K that year. Not that much.

But, as with everything else, when it comes to taxes, this factor could change in the future so it's something to keep in mind, as you suggest.

As for taking a loan by using the retirement account balance as collateral, and thereby reducing my tax rate (ordinary income tax rate), I am still looking into this scenario and would be interested if anyone knows anything about how to accomplish this.
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FoolishMiser,

I believe you missed one important point.

Any withdrawal from your 401K, other than rollover, will be subject to income tax.

When you payback the loan, there is no free transfer to the bank. There just isn't any such animal. You will pay income tax on that transfer.

Gene
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Hi,

The only "animal" I've found so far that may provide a way around income taxes on a withdrawal from a 401K is ROBS:

http://en.wikipedia.org/wiki/Rollovers_as_Business_Start-Ups...

Any insights on this kind of arrangement?
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I don't see any issues with it. Sounds like a solid plan to the other side of the tracks.

New Business Failures

Preliminary results from the ROBS Project indicate that, although there were a few success stories, most ROBS businesses either failed or were on the road to failure with high rates of bankruptcy (business and personal), liens (business and personal), and corporate dissolutions by individual Secretaries of State. Some of the individuals who started ROBS plans lost not only the retirement assets they accumulated over many years, but also their dream of owning a business. As a result, much of the retirement savings invested in their unsuccessful ROBS plan was depleted or ‘lost,’ in many cases even before they had begun to offer their product or service to the public.


Gene
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Gene,

Granted, the so called "preliminary results" came out of a study conducted by the IRS itself.

This from an IRS memo describing the transaction:
------

An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.

The plan document provides that all participants may invest the entirety of their account balances in employer stock.

The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point. there is still no ownership or shareholder equity interest.

The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan. These available funds might be any assets previously accumulated under the individual’s prior employer’s qualified plan, or under a conduit IRA which itself was created from these amounts. Note that at this point, because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the
distribution have been avoided.


The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.

The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note that all otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.

After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.

A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.
------

Again, my original question to this forum began with an exploratory tone, looking to better understand the outer boundaries of a 401K. I hope that in answering my original post, you've learned something new today :).
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I've never heard of this and it seems unlikely to me that a bank would accept it. Granted, my understanding of collateral has at least as many holes in it as your understanding of 401(k)'s. But why would they accept as "collateral" an account you could then turn around and empty?

Also, what do you mean by "transferring this amount in 401K shares to the bank"? What is a "401K share"?

73k a year in RMDs is pretty close to the 100K your hypothetical retiree needs. It would be less complicated to arrange for the other 27k to be in a Roth IRA.
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FoolishMiser,

I have been away from this thread for a while.

So, at this point your $2M 401K is now invested in a business. How is this going to pay the bank loan?

Proceeds from the business will be taxable for federal and state corporate rates.

I do not see anything here that I have learned about 401Ks other than there are a number of ways to make them complicated.

If I wanted a business to run in the future, this method is a way to do it, but I believe there is more to it than this very brief explanation. Also, I wonder if there is an additional tax consequence to selling the business in the future.

If this scheme was so simple and was a guaranteed tax dodge, nearly everyone would do it.

Gene
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