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About 15-20 years ago (so late 90s-ish), I had some extra money (a few thousand US dollars) that I was considering putting into a short term investment to at least keep pace with inflation. Something like a CD or money market. At the time, I think they were offering somewhere in the 3-5% range per year return.

I went to one bank where they suggested that I borrow money out of my 401(k) to invest in their CD or money market, with the salesman enthusiastically telling me that I'd end up paying the interest to myself so it was somehow better than just putting money directly into the CD/money market.

From where I sat, it sounded like taking money out of a long-term, high risk/high reward scenario and moving it into a short-term, low-risk/reward scenario, and then owing interest on the result. I'm sure that would work out great for the bank, but I didn't see how it would benefit me. I went somewhere else.

Was I being naive and this was some great strategy I didn't understand, or did I understand it correctly and was better off not doing it?

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  • You were misremembering the details. Taking money out of a (Traditional) IRA would have triggered taxes and penalties, not interest that you "owed" anybody. Putting that money into a CD outside the IRA when you could just as well have left it in the IRA and invested in the same CD inside the IRA would have been a far better thing to do. If your bank salesman really suggested what you claim to remember, it would have been fraudulent, but likely unprosecutable. Especially today, fiduciary duty can be a custom more honored in the breach than in the observance... – Dilip Sarwate May 24 '18 at 2:41
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    That sounds absurd to me. Particularly since you'd likely have to pay penalties and taxes for an early withdrawal from the IRA. However since we don't have any idea what they were selling you I doubt anyone can give you an answer. I don't wish to impugn the entire retail bank industry, but as the recent scandals with Wells-Fargo show, they can sometimes go completely off the rails into fraudulent behavior. – Charles E. Grant May 24 '18 at 2:41
  • Thanks for the info! It's possible I'm misremembering, but I remember feeling shocked that a banker would suggest taking money out of an IRA. (My IRA was a Roth IRA if that makes any difference.) It sounded very irresponsible to me. – user1118321 May 24 '18 at 2:44
  • He meant probably borrowing from the 401k. Taken it permanently out is insane, yes. – Aganju May 24 '18 at 2:45
  • "I'd end up paying the interest to myself " Yes, this sounds like he was telling you to borrow it from your 401K, rather than cash out the 401K. – Norm May 24 '18 at 17:14
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There are many things to consider, but you are right that it is a good deal for the bank for sure.

  • if you borrow from your 401k, you will not be able to borrow if you are in dire need (your roof crashed in or such).
  • if you lose your job (or change voluntarily, or the company ends their 401k), you owe all the money immediately back - or it is considered a taxed early withdrawal, which comes with an extra tax. That can hurt badly, and you might end up taken even more out to pay the taxes you owe (and then more to pay the taxes you owe on the 'more', etc.)
  • yes, you are paying interest to yourself; but you are missing out the gain that investment would have made if you wouldn't have taken it out. The numbers vary of course, but just as an example: long-term you can make an average of 10% per year with the money in the 401k. If you put it in a CD, it makes between 0 and 5 % (depends a lot on the interest rates). That's an expected loss of 5-10%, right? In addition, the interest you pay to yourself doesn't grow on trees either, so you are limiting your cash-flow.
  • the interest on the CD is taxable income. The interest you pay to yourself is not tax-deductible. So you are paying extra taxes.

Overall, this is rarely a great idea. I would struggle to construct a situation where it would be even acceptable.

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  • I thought I saw 401k in the question when I wrote the answer? With an IRA, it is completely absurd. Everybody tries to get as much as possible into the IRA. – Aganju May 24 '18 at 2:46
  • I said IRA. It's possible it was a 401k that I had from a previous job and had not yet rolled over into my IRA. It was 15-20 years ago, so I may not be remembering every detail exactly. Sorry for the confusion! – user1118321 May 24 '18 at 2:47

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