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I am allowed to borrow (tax free) up to 50% of the current vested amount in my 401K. The value of funds borrowed are put in a guarranteed income fund currently paying around 6%. I will have to make monthly payments at a rate of approximately 8.5% which in reality is paid back to my account. I am paying myself.

Thinking that I can do better then the mutual funds offered thru my 401K, I have been considering borrowing 50% of the 401K and investing the borrowed funds using the Dow Dividend approach or the FF4. Not only would this provide me the opportunity to self direct the investment of tax free funds, but also would give me liguidity on my investment returns (returns are taxable of course).

One risk is that the borrowed funds are 100% due and payable upon employment termination, whether voluntary or via lay-off. If the borrowed funds are not paid back then it coverts from a loan to a taxable distribution.

Any opinions on this investment approach.
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Any money borrowed from your 401k is just...well...money. Since your returns are 100% taxable, they have to be that much better, with fed and state taxes discounted for. Never ignore taxes when calculating returns.

Another way I can see this working, after a fashion, is to borrow $2000 for your IRA, at the beginning of the year, and paying that back during the year. You could then plunk it all into an FF4 portfolio immediately.

Zev
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Nid asks:

I am allowed to borrow (tax free) up to 50% of the current vested amount in my 401K. The value of funds borrowed are put in a guarranteed income fund currently paying around 6%. I will have to make monthly payments at a rate of approximately 8.5% which in reality is paid back to my account. I am paying myself.

Thinking that I can do better then the mutual funds offered thru my 401K, I have been considering borrowing 50% of the 401K and investing the borrowed funds using the Dow Dividend approach or the FF4. Not only would this provide me the opportunity to self direct the investment of tax free funds, but also would give me liguidity on my investment returns (returns are taxable of course).

One risk is that the borrowed funds are 100% due and payable upon employment termination, whether voluntary or via lay-off. If the borrowed funds are not paid back then it coverts from a loan to a taxable distribution.

Any opinions on this investment approach.


Say you have $20K invested now that's earning 9%. Left alone, that money would grow to $30,772 in five years. For someone in a marginal bracket of 28%, that amount has an after-tax value of $22,156 at that point in time. Instead, you borrow $10K to invest elsewhere. Immediately, the $10K remaining in the account to secure the loan gets switched to something paying 6%, so in five years it's worth $13,382. You amortize your loan over 60 months at 8.5% per year, so your monthly payment is $203.72. That means over the life of the loan you put $12,223 back into the account of which $2,223 is interest you pay yourself with after-tax money. Guess what? It's considered earnings in the 401k, so when withdrawn it gets taxed again. Your account is now worth $25,605 ($13,382 + $12,223), or $18,436 after taxes. That borrowing just cost you $3,720 ($22,156 - $18,436). Leave your job for any reason while the loan is outstanding, and a failure to pay the outstanding balance in full will cost you more dollars because of taxes and the 10% penalty for the early withdrawal on the deemed distribution.

On a pre-tax basis, that same $203.72 monthly payment would be worth $282.94 as a 401k deposit. Putting that into the 401k as a deposit instead of a loan, starting the 401k with the same $20K, and earning 9% per year, the account would grow to $52, 814. After taxes, that is a net of $38,026. Now the loan has cost $19,590.

Let's look at the use of the loan. Say you average the historical return since1961 of 17.4% on the $10K invested in the FF4. Of that, historically 4.7% is dividends (taxed at 28%) and the remaining 12.7% is capital gains (taxed at 20%). The after-tax return is thus 13.5%. Accordingly, that $10K will grow to $18,836 after taxes. Add that to the $18,436 after-tax result of the 401k loan and you wind up with $37,281. That's some $745 worse than using the 401k with the added loan deposit on a pre-tax basis.

What happens, though, if you took the $203.72 and invested it for two years at an after-tax return of 9% and then for three in the FF4 at an after-tax return of 13.5%? Your account would be worth an after-tax $17,122. Add that to the untouched 401K after-tax amount of $17,122. Add that to the untouched 401k after-tax result ($22,156) and you get $39,278. That beats the 401k with the added deposit by $1,252 ($39,278 - $38,026).

Just looking at all that, Nid, I don't think much of your plan. To me, borrowing from your 401k for this purpose just doesn't make much sense. That loan repayment can be put to better use elsewhere even if it's in the 401k as an increased deposit.

Regards…..Pixy
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