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I am a self-employed independent contractor. I'm trying to decide what to do with any extra income I earn over the near future, given that I have the eventual goal of purchasing a house (within 2-3 years). I have no current outstanding debts.

In essence, I'm trying to decide whether to save the excess as cash (which would eventually increase my downpayment amount, after tax), or put it into a pre-tax individual 401(k), from which I could draw a 401(k) loan to put toward the house. I realize that 401(k) loans aren't always as attractive an option as they may seem, so I'm trying to get more input on what would net me the most purchasing power toward the house.

For the sake of argument, suppose the 401(k) would be with a custodian that offers low-fee index funds. Because I am self-employed, the "lose your job" drawback of drawing a loan against an employer sponsored 401(k) plan doesn't apply (in other words, I won't face an immediate payback provision). Of course, there is still the risk that I could lose my contract, but I am reasonably confident I could find another gig within a short enough time frame that making the loan payments won't be a concern.

Given that money can go into the 401(k) pre-tax, and that once the loan is paid off, the principal is restored, I'm having a hard time seeing the downside of this approach. Am I missing something or does it actually make sense in my situation?

  • I don't know much about 401K's (I use an IRA-SEP). So I'm wondering: are there any fees associated with pulling money back out of the 401K? How long do you have to pay it back before there is any penalty? – Clay Nichols Jun 10 '13 at 14:25
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    Does your 401(k) custodian permit loans? Last I looked at the Solo-401(k), the few I read through had no loan or Roth 401(k) provision. – JTP - Apologise to Monica Jun 10 '13 at 15:32
  • @JoeTaxpayer, you're right that it might be tough to actually find such a custodian. I read through the information here and assumed they exist, but I haven't specifically reached out to all of them to inquire yet. I guess this question may turn out to be more academic in nature than I had hoped. – Jeff Evans Jun 10 '13 at 20:26
  • @littleadv set me straight, I wasn't seeing the loan provision because they are not offered for solo0-401. – JTP - Apologise to Monica Jun 10 '13 at 22:14
  • After some more research, I'm fairly convinced that this is, in fact, now a purely academic question. I heard back from some of the custodians I was considering and none of them offer such a provision, as many here were suspecting. – Jeff Evans Jun 13 '13 at 19:00
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Given that money can go into the 401(k) pre-tax, and that once the loan is paid off, the principal is restored, I'm having a hard time seeing the downside of this approach. Am I missing something or does it actually make sense in my situation?

You're missing several things. Here's a list of what I could think of:

  1. Loans are not always permitted for Solo 401k's. In fact, I think it would be rather difficult to find a provider that would allow that. So you have to verify that it is at all possible.
  2. Loans from 401k come with strings attach. You need to read the plan documents very carefully to know how and when you must repay the loan for it not to be considered a distribution subject to the 10% penalty + tax. Even though you might not have the "termination" provision, there might be some other similar provision specific for self-employed.
  3. Loans cost money. You pay interest on the loan, which means that in this scenario - you're going to pay interest for getting your own money.
  4. You can only get up to 50% of your balance (or 50K, the lesser) from 401k as a loan, at most. The plan may have other (lower) limits, or not allow loans at all.
  5. Banks are not happy when downpayment is based on loan proceeds. I had to sign an affidavit where I state that the downpayment is not from any loan or debt, last time I took a mortgage.

You should make sure that none of these issues is a problem for you.

  • Thanks for the answer. I definitely agree that these are valid considerations. All I would say is that for #3, the interest is going to yourself. Specifically, the loan you take from the 401(k) just becomes another investment vehicle. Granted, it may have a lower effective return than some of the alternative options available to you, which would count as an opportunity cost, but that's not necessarily the case. – Jeff Evans Jun 10 '13 at 20:29
  • @jeff303 just checked my own 401k loan specs - the interest is 0% (i.e.: your 401k doesn't earn anything on this, but you also don't pay any extra), but I have to pay origination fee of several hundreds of dollars (which goes to the plan administrator - cost to you). – littleadv Jun 10 '13 at 20:38
  • +1 and a good answer. I agree there's risk, but #3 isn't so clear. If one were 100% certain of employment (not possible, I know) there are times a loan at say 5% might make sense. And there are times that one would wish the cash potion of their 401(k) to earn 5% instead of the .25% they earn now. It needs to be looked at as two transactions. Moot points here as no loan for solo-401 which I wasn't aware. – JTP - Apologise to Monica Jun 10 '13 at 22:14
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Your question boils down to saving for a house or saving for retirement. Why not do both?

If you invest in a Roth 401k or Roth IRA you can withdraw any contributions that are at least 5 years old without penalty (assuming you're willing to put off purchasing a little longer than your original 2-3 years). If you qualify as a first time home buyer (i.e. you haven't owned a home in at least 2 years) you can withdraw investment earnings as well if your distribution is earmarked towards the down payment and is no more than $10000.

Although you won't be penalized for using investment earnings for a down payment you will still have to pay taxes on them. So this may be more appealing to someone that has enough contributions to avoid dipping into the investment earnings.

The only other downside is that contributions to a Roth investment are not tax deductible like Traditional IRA and 401k contributions are. Instead, they grow tax free and distributions are tax free when you reach retirement age.

  • But withdrawal means you lose the tax benefit, and the OP wants to keep the tax benefit by taking a loan instead of withdrawal. He mentioned that quite explicitly. The 10k you withdraw (or what you withdraw from Roth after 5 years) cannot be replaced. – littleadv Jun 10 '13 at 19:40
  • I'm simply pointing out an alternative he may have not considered. Depending on how much he contributes he may not have to tap into the earnings at all, in which case he could always "pay" himself back by continuing and/or increasing future contributions. – Kenneth Cochran Jun 10 '13 at 20:21
  • Thanks for the suggestion. But my income will exceed the Roth IRA contribution limits. So if it can be done through a backdoor Roth IRA, then it's definitely an option. But as @littleadv points out, I would be unable to eventually replace the principal, which is one clear drawback. – Jeff Evans Jun 10 '13 at 20:32
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If it were my money, I wouldn't put it in a 401(k) for this purpose.

If you were working at a company that provided 401(k) matching, then it might be worth it to put the money in your employer's 401(k) because the employer chips in based on what you put in.

But you're self-employed, so there's no matching unless you match it yourself. (Correct?)

So, given that there's no matching, a 401(k) arrangement would have more restrictions than a non-tax-advantaged account (like a bank account, or a taxable money market account). This would be taxable in the year you earn the money, but then that's it.

If you're expecting to pull out the money pre-retirement, I wouldn't put it in in the first place.

  • For self employed, a solo 401k is a great tool - you can defer more than $50K a year for retirement. – littleadv Jun 11 '13 at 9:38
  • I didn't know that piece of information. Thanks for sharing it. – mbhunter Jun 11 '13 at 19:11

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