Sometimes, a 401(k) Loan Could Be a Good Thing

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While trying to time the market is a flawed and futile exercise, timing the taxation of investments is not. In fact, as an “advisor” (not “adviser”) I would argue this is mandatory.

Recently I wondered, could we use a hated, dreadful tool, like a 401(k) loan to financial benefit the consumer? Yep, I’m that cool that in my spare time my thoughts are perpetrated by fun ideas like that. As boring as it sounds, a 401(k) loan can be useful if the loan proceeds are deposited into a Roth IRA. Odd but true!

There are three main components that make a 401(k) loan/Roth IRA combination advantageous.

First, it is the manipulation of consumer behavior. In my experience, individuals who take out a 401(k) loan do not factor the slight additional federal tax liabilities into their decision.

Second, if we take the loan after a short-term negative fluctuation in value, then we can exploit the “buy and hold” strategy, or the “the-market-will-always-back” belief, by paying the tax on the depressed amount and allowing the growth to be tax-free (similar to the required minimum distribution example). Thus, allowing for increased withdrawal capacity.

Third, tilting the Roth to be completely growth creates a definitive mathematical advantage. Interestingly, except for the increased withdrawal capacity, the first two benefits are purely behaviorally superior while mathematically equal; whereas, the third and final benefit is mathematically superior while behaviorally inferior.

Timing the taxation of investments to take advantage of short-term market fluctuations isn’t as difficult as it sounds. In fact, I bet you’re already doing it.

I want you to imagine one of your clients, Bob and Mary, who own small business, have just shared that their income this year will be the lowest it’s been in decades. They expect their taxable income to drop from north of two-hundred large to just about fifty-grand. You all agree this is a short-term fluctuation (think industry shift, or unusually large depreciable deduction) and although it’s painful to pay additional taxes right now, you show them how a partial Roth IRA conversion would take advantage of their unseasonably and temporarily lower marginal rate. Very important, although often overlooked, Roth IRA distributions do not factor into whether future social security benefits are taxable, since all the growth is 100% tax-free.

There’s other examples of how we can utilize tax rules to increase net investment gains, but the 401(k) loan is one I haven’t seen mentioned before. Let’s get the icky part of this over.

Yes, I know a 401(k) loan typically has a reasonable interest rate, and yes, it’s true the interest paid goes back into the loan recipient’s 401(k), but the loan repayment is characterized as income, making the interest double taxed (only the interest since the “principal” already reduced the tax liability once and was not taxed when it came out as a loan). Most importantly though, too often I’ve seen a 401(k) used as a quasi-emergency fund, which it is not.

If you believe the market will always come back, then we can manipulate when taxes are paid to capitalize on negative short-term market fluctuates. Further, we can use negative consumer behaviors to increase long-term consumer successes.

Read more on ThinkAdvisor.com

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