Taking out a 401K Loan vs. Liquidating Investments - what's better?

Question

Let's assume the following:

1. I need $50K for various expenditures (aka simply spending, not paying off CC debt or putting the money somewhere else).

2. I can either liquidate regular taxable investments and pay 15% LT capital gains taxes which amount to about $5K in this case. So, in order to keep $50K I'd have to liquidate $55K.

3. Or I can take out a 401K loan for $50K (repayment 5 years).

Which alternative is better?

Maybe my thinking is incorrect, but it looks to me that taking out a 401K loan is the better option due to the tax effect of liquidating taxable investments.

1. FV of $55K in taxable investments over 5 years at 9% annual return (LT S&P500 return) = $84.6K
2. FV of $50K in 401K over 5 years at 9% annual return = $76.9K

The delta between 1 and 2 is of course the FV of the capital gains taxes (same 5 years, same 9% return) I avoid by taking out a 401K loan.

I'd argue that the fact that the 401K loan needs to be repaid does not matter here. Nor does future tax treatment for the taxable investments or the 401K -- basically, the money is where it is.

Is it really that simple? What am I missing? Seems to fly into the face of the many articles that say "never take out a 401K loan".

Thanks for your critique! ;-)

Answer 1

There may be little practical difference between these options.

First, you shouldn't count the entire capital gains tax as a cost of liquidating investments, because if you opt for the loan and don't sell now, you'll probably owe capital gains tax anyway whenever you sell later. Or to put it another way, without a 401(k) loan, the money you'd otherwise use to repay the loan would presumably be used to repurchase the sold investments at their current, higher price (basis), saving you taxes in the future.

The biggest issue is to ensure that your 401(k) plan permits continuing regular contributions during loan repayment. It appears that many do. If not, even if you save the money elsewhere, you would lose the employer match and tax deferral benefits during that time.

You don't seem to be at significant risk of penalties for failing to repay a 401(k) loan if you lose your job, because you have sufficient liquid assets to repay it quickly if necessary.

The remaining potential difference is that a 401(k) loan reduces the amount of money that is protected in the event of bankruptcy. In a worst-case scenario where you face large medical bills or a lawsuit, you have $50k more to lose if you've just taken a loan.

Answer 2

Seems to fly into the face of the many articles that say "never take out a 401K loan".

You need to look at the date of the articles. The Trump tax plan removed some of the gotchas with 401K loans. Mainly you now have at least a year to pay back the loan, when you leave an employer, where you only had 30 days (IIRC) previously. Most people cannot come up with 50K in that time frame.

Doing a quick search it seems that many have changed their tune about 401K loans including this article.

However, this was never an issue with a person who had enough cash to pay back a 401K loan in a taxable account. Very few people find themselves in that situation.

You may be much better off borrowing from a 401K for reasons other than you state. Since your 401K has limited investment choices and may charge fees your taxable might perform much better.

However, one must realize that personal finance is mostly about behavior and little about math. Because of that, for most, a 401K loan is the worst idea. Neglecting to pay it back leads to all kind of dire consequences. So a good knee jerk reaction is to avoid 401K loans.

Even if one behaves well, bad things could happen. The economy could see a major correction. One can lose their job and see their taxable account diminish to a fraction of its value. What do you do then — use the taxable account to make ends meet, or pay back part of the 401K loan? If a job, with a living wage, is more than a year off you could find yourself in a bad way with your 401K loan.