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Subject:  Re: The downside of 401k loans... Date:  2/10/2015  12:06 PM
Author:  aj485 Number:  309009 of 312956

DW and I bought a house last year, and took out a 401k loan to help pay for some remodeling. Figured we'd be fine to pay it back over a few years. Without getting into too many details, we're quite likely going to have a change that requires us to repay the 401k loan, or count it as a disbursement in 2015. So, I'm weighing my options and would welcome input. No need to second guess our choice to take out the 401k loan, other than to let this be a warning to others. ;)

Sorry to hear about this. As I have said before, never take out a 401(k) loan unless you have a solid plan to pay it back, because you can't always choose when you want to pay it back. Sometimes it's that you just don't get a choice (like when you get laid off) and sometimes it's because it's a better choice for the rest of your life (like when you choose to take a different job). I hope yours is one of the latter, rather than the former.

That said, let's look at your situation:

-We don't have enough liquid reserves to comfortably repay the entire loan. If we did, we wouldn't have taken the loan (obviously).

-We're solidly in the 28% bracket, and counting the loan balance as income would push us a bit into the 33% bracket. I expect the tax hit (with 10% penalty) would average out to about 40% of the balance if we count the loan as a distribution.

-We do have enough liquid reserves to cover the tax hit if treated as a disbursement. Wouldn't be happy about it, but we could do it if needed.

-We could take out a HEL to satisfy the loan and avoid a tax consequence. Payment terms would be similar, but we'd be paying interest to the bank (4.5-5%).

-We could take money from another 401k to repay the loan. Avoids tax consequence, but the repayment terms would be shorter, meaning a higher monthly payment. This would probably force a reduction in 401k contributions while in repayment. Which I guess technically leads to some additional tax paid, but at our marginal rate, rather than a penalty rate.

Okay, so reading between the lines, here's what I am assuming (and the assumptions are important, so you will need to re-run the numbers with the any corrections, if my assumptions are wrong):

- Current 401(k) loan - $50k original balance at prime (3.25%) taken out 6 months ago (about when you purchased your home) for 10 years - monthly payment is about $490. Current balance is about $48k.

- New 401(k) loan for $48k - will need to be over 5 years (because not associated with the purchase of a home) and is at prime + 1, or 4.25% - monthly payment will be about $890, or $400/month more than the current loan. If you take the additional cash flow requirement out of your 401(k) contributions, so that you don't have to change your lifestyle at all, you would cut about $4.8k a year from your planned 401(k) contributions.

- Home Equity Loan for $48k - PenFed is showing a 10 year HELoan that will bring your LTV up to 85.1% - 90.0% will be 5.24%. The payments on this loan would $515, or $25 more/month than your current loan. Over the course of the loan, if you make the minimum payments, you would pay about $13.8k in interest. Additionally, assuming you are already itemizing, the interest would be deductible, since it is traceable to money used to purchase or substantially improve your home. Even if weren't traceable, it's less than $100k, so it's still deductible. Assuming you start the payments in March, this year that would give you about $1,850 in interest to deduct. At 28%, that would save you about $518 - which would more than cover the $25 increase in payments. It would lengthen the term of your loan by about 6 months, which could be offset by adding about $20/month to your payment, or a $535/month payment.

- Home Equity Line of Credit (HELOC) - variable rate that is currently lower. PenFed is offering a HELOC that would bring your LTV up to 85.1% - 90.0% at prime + 1 (same link as above, just farther down on the page). Caution - the rates on this loan have a floor of 3.75% and a cap of 18%, so if rates go up substantially, you will end up with higher minimum payments, and paying more interest. At the current rate of 4.25%, if you want to pay the loan off in 10 years, your payment would need to be about $490/month. Interest would still be deductible.

- Refinance your current loan, adding $48k (possibly plus closing costs) to it - Current Jumbo rates at PenFed are 3.75% (paying 1.25 points) to 4.00% Not knowing what your current rate is, you would have to figure out what the difference in the payment would be.

- Pay the penalty and taxes - A $48k distribution - you said that the additional income would push you into the 33% bracket, so the taxes would be somewhere between $13,440 (at 28%) and $15,840 (at 33%). If we assume somewhere in the middle - it's about a $14.5k hit. The penalty will be another $4.8k on top of that - so, we'll call it a $19.3k hit. That's $6k more than the cost of a HELoan. Additionally, considering that the tax and penalty hit is all due by April 15, 2016, while the HELoan interest is deductible and paid out over 15 years, the NPV of the HELoan cost is even lower. Plus, there are lots of things that start to kick in from a tax standpoint when your taxable income is high enough to put you in the 33% bracket, like AMT, decrease in personal exemptions and decrease in deductibility. So, I would caution you to look very closely at your tax situation before deciding to take the tax/penalty hit.

DW has opined that she's willing to take the tax hit, as she doesn't think the total cost is that much higher than the total cost of a HEL over a 10 year term.

I think that DW should probably look at the numbers before making a decision. To me, having to pay $13.8k in deductible interest over the next 10 years would be much more preferable than having to pay $19.3k in penalties and taxes in the next 14 months.

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