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Asking for a friend.... j/k

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. ;)

-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.

-We're pretty unbalanced as investors, with 90%+ of our assets in 401k accounts. A lot of our non-401k money went into the house purchase/reno last year.

So I'm in a quandry, and admit I haven't fully thought through the scenarios yet. Our options are to shift the loan to another 401k, shift the loan to a HEL, take the tax hit, or some blend of the three. I'm just not sure which one leaves us in the best position next year, or 5, or even 10 years down the road.

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. Not sure that I agree, but I haven't done the calculations to back it up yet.

Also, FWIW, we have both contributed the maximum to our 401k accounts for years. We're in our 30s, and have accumulated about $500k there.
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I've got no answer, but having considered taking a 401k loan to put a bigger down payment on a house I'll just add that I heed your warning.
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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%. https://www.penfed.org/Home-Equity-Loans-Overview/#tabs-2 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.

AJ
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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.

And I forgot to add - along with paying about $5.5k less in interest (even more if you pay off the HELoan earlier), you will be putting $48k back into your 401(k) plans that won't be there if you decide to take the money out as a distribution. Assuming 20 years growth at 6%, that's an additional $154k in your 401(k).

AJ
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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.

Nice analysis, AJ.

I would add to your analysis the possible return on the 401(k) by repaying the current $48k 401(k) loan with the HEL. While the OP could be paying $13.8k in deductible interest over the 10 years on the HEL, he could also be earning about $28k on the $48k in the 401(k) assuming a modest 5% return (assumed constant) over the 10 years. That's even more reason not to pay the penalties and taxes.

PSU
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And I forgot to add - along with paying about $5.5k less in interest (even more if you pay off the HELoan earlier), you will be putting $48k back into your 401(k) plans that won't be there if you decide to take the money out as a distribution. Assuming 20 years growth at 6%, that's an additional $154k in your 401(k).

I should have read ahead.

PSU
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I should have read ahead.

It's probably a point that bears repeating.

AJ
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Bless your heart.

PSU
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Thanks for the detailed analysis, AJ. You're one of the reasons why I come to this board. Even your assumptions are remarkably close to the actuals.

My current mortgage rate is 4.09%, and I think the loan fees would make refinancing unattractive. We originally financed 80% LTV on the purchase, so we'd be talking about a jumbo approaching 90% LTV to roll everything together.

Of the other loan options, the HEL definitely seems the most attractive in terms of monthly carrying cost, and I can get 4.5% for 10 years through my credit union. I discount he HELOC because I'm not a fan of variable rate loans.

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.

Great point. I looked up the personal exemption phaseout, and we'd still be under that threshold. Not sure about other deduction phaseouts, and AMT is completely unknown to me - we don't pay state income tax, so we don't have massive deductions and have never triggered AMT before. Still, there's a lot of cause for concern on that front.

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.

I'm going to make this argument, but she's not much of a numbers gal when it comes to finances, lol. In her mind, it's $13.8k paid plus $48k, vs a one time $19.3k and walking away. As both you and PSU mentioned, the long term value of that $48k is potentially much greater. I get that. Convincing her to see it that way is my challenge. She's good (great) at many things, but financial matters is not one of them.
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Oops, sorry - copied the wrong part of the post. The part that I thought was important to repeat was the part about having more money in the 401(k).

AJ
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As both you and PSU mentioned, the long term value of that $48k is potentially much greater. I get that. Convincing her to see it that way is my challenge. She's good (great) at many things, but financial matters is not one of them.

I think sometimes putting the facts on paper in as simple form as possible and allowing a person to read them before having a discussion can be helpful. I wouldn't bother with the calculations or assumptions. Just a simple table or list showing the final numbers. AJ gave you many of the number you need. Just leave off the discussion.

PSU
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I'm going to make this argument, but she's not much of a numbers gal when it comes to finances, lol. In her mind, it's $13.8k paid plus $48k, vs a one time $19.3k and walking away.

Maybe if you show her the statement where the 401(k) balance went down by $50k, and remind her that the money won't be going back in if it's taken as a distribution? That way, she can compare the $13.8k + $48k to $19.3k + $50k.

As both you and PSU mentioned, the long term value of that $48k is potentially much greater. I get that. Convincing her to see it that way is my challenge. She's good (great) at many things, but financial matters is not one of them.

Well, I hope that you can convince her, as it would be a really bad decision to pay taxes and penalties, IMO.

AJ
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Maybe if you show her the statement where the 401(k) balance went down by $50k,

And unfortunately, that's part of the problem. It doesn't register fully. The 401(k)'s did well last year. Really well, actually. The sum of our accounts today is actually higher than it was before we took out the loan. I think that's part of the reason why she's willing to let it go. But it seems clear to me that the HEL is the way to go...
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And unfortunately, that's part of the problem. It doesn't register fully. The 401(k)'s did well last year. Really well, actually. The sum of our accounts today is actually higher than it was before we took out the loan.

Can you show her how much higher they would be if you had left the $50k in? Not just the $50k, but the $50k plus the growth that it would have had, minus the small amount of payback that has occurred?

I think that's part of the reason why she's willing to let it go. But it seems clear to me that the HEL is the way to go...

Good luck! I hope that you can convince her that the $50k was gone once you spent it on the renovations.

AJ
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Some 401K plans allow repaying of loans on the existing terms after separation from your employer. Have you verified that you will need to pay the loan back immediately?

with 10% penalty

Federal tax penalty, your state may add additional penalties

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.

Since you already have a 401K loan, this isn't a bad option but maybe not the best. This essentially defers a decision while avoiding tax penalties. If you just purchased a house in the last year, a HEL may not be easy to obtain.

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

With so little liquid assets outside of a 401K, keeping the cash for emergencies would be a good idea.
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I don't know if this an option for you or not, but there are some pretty good 5/1, 7/1, and even 10/1 loans out there now -- even ones which are interest-only during the fixed rate period. You could take out one of those, pay off both existing loans, have a lower monthly cost, and have some time to get yourself stabilized financially. Once you reach that point, you can build up some cash reserves then refigure your strategy.

My position is different than yours, but here's what we did:

A couple of years ago, I swung a great deal on a 10/1 ARM at two and seven-eighths interest only. Our monthly payment dropped to about $360/mo. and the savings on mortgage payments go into our Roths.

We'll both be at full retirement age (about year 8 of the 10-year period) and are set up to do any of the following:

- Keep going with the loan (it has a 4 and 7/6 *total* cap after year ten).
- Refi.
- Sell the house, take our equity, and go elsewhere.
- Pay off the house with the savings and earnings we've realized from them.

I don't know all the qualifications & hurdles involved in using those types of loan instruments, but we seemed to sail through them pretty easily....
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I should have read ahead.

PSU


I've never seen AJ make an analysis and leave out any reasonable scenario. Ever.

I mean you know me, I read posts looking for things I can correct or expand on. I just don't even read AJ's posts any more. They're a waste of time. They're always accurate and complete. Stupid AJ, ruining my forum fun with her danged aptitude. ?

xtn
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The sum of our accounts today is actually higher than it was before we took out the loan. I think that's part of the reason why she's willing to let it go. But it seems clear to me that the HEL is the way to go...

It sounds like the calculation here is more about having it paid off and not having to deal with it anymore versus the future value of your retirement accounts, if I am reading that correctly? Because I think the math is clearly on the HEL side.
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I'm going to make this argument, but she's not much of a numbers gal when it comes to finances, lol. In her mind, it's $13.8k paid plus $48k, vs a one time $19.3k and walking away. As both you and PSU mentioned, the long term value of that $48k is potentially much greater. I get that. Convincing her to see it that way is my challenge. She's good (great) at many things, but financial matters is not one of them.
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And unfortunately, that's part of the problem. It doesn't register fully. The 401(k)'s did well last year. Really well, actually. The sum of our accounts today is actually higher than it was before we took out the loan. But it seems clear to me that the HEL is the way to go...


If you want to avoid talking so much about numbers, another approach you might take is talking about how when you borrowed the money from the 401(k) you, as a couple, made a commitment to pay the money back to the 401(k) through the payroll deductions, just like you might have with a loan from a bank or your CU where you could have automatic payments deducted from your checking account. Now that that you will no longer be able to use payroll deductions to make those payments, you, as a couple, still need to find a way to put the money back into the 401(k). Otherwise, you would be defaulting on the commitment that you made to yourself and your retirement funds. The best way that you see to do that is to pay back the money to the 401(k) by getting a HEL - the payments will be pretty similar to the payroll deductions that have been taken out, and as an added benefit, the interest paid will be tax deductible.

Also, you might want to talk about how the cost for the HELoan is not the $13.8k in interest plus the $48k - you are actually getting $48k from the bank when you take out the HELoan, so the true cost of the HELoan is just the $13.8k in interest (which will be reduced even further by the tax deduction) vs. the 19.3k in tax and penalty.

AJ
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Have you considered selling a car or two ?
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Have you considered selling a car or two ?

Nope, and I don't think there'd be much of anything to gain by doing so. We have two cars, and need two cars. One car is paid for and worth about $14k. The other might bring $25-30k, but it'd be a slow sale (unless priced absurdly low), and has a $15k loan outstanding. So we'd likely net around $25k and then need to find two replacement cars for us. Realistically, that's just not going to solve the 401k loan issue.

Now, one thing I am considering is paying off the $15k car loan using a bonus and ESPP sale coming at the end of next month. Between that and clearing the 401k loan obligation, we could easily cash flow a HEL, actually come out a few hundred $ a month ahead. That seems like the clearest path to me right now.
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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 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.


OK - take your liquid reserves, pay back whatever you can and then take the loan from the other 401K to pay the balance.

I am not sure what "change" you are going through that requires paying back the original loan, but if it means you get the opportunity to roll over the 401K into a new one, then after you do that - take out another loan to pay back the funds used to pay back the original loan. Sounds temporary to me, but I could be wrong.

Just a side note: About 18 months ago, I took a 401k loan with payments that I could easily afford and immediately invested the entire amount. The investing (mostly doing swing trading) is now worth 4x the original loan amount and the current loan balance is now paid down by around 1/3. My strategy was to keep my 401k secured PLUS use it to generate money. It worked out extremely well for me. I can pay off the loan at any time and probably will in the next few months (but I think I will also turn around and take more money out after that).
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