Rollover for new loan to pay off prior loan

[Guest Pecos]

I recently changed employers and have an oustanding loan on my former 401(k) plan. My former employer will allow me to keep my funds in their plan as long as I have over $5,000 balance.

What I would like to do is rollover half of my funds from my prior 401(k) into my new employers 401(k). Than take a loan against my new 401(k) (rollover funds) and use those funds to pay off my outstanding loan with my prior employer's 401(k) plan? Can I do this to avoid the 10% distribution penaly + 20% in taxes? Or is there any easier way to pay back the prior loan?(I don't have enough cash on hand to pay it back within the 90 days).

[masteff]

That should work just fine. You'll need to ask the benefits person/dept at your new employer to find out how the rollover check should be made payable (due to certain rules, some places are very picky about the wording, you can make it go smoother by getting the wording they want used).

You'll then ask for a "direct rollover" from your prior employer. In a direct rollover, the check is paid to the new plan and not to you. This avoids w/holding. By doing the rollover, you'll avoid any tax or penalty.

Oh, and doublecheck w/ your new employer (if you haven't already) that they'll let you get a loan that quickly against your rollover monies. It usually isn't a problem but better safe than sorry.

[rcline46]

Also make sure you can take a partial distribution from your old plan. As a terminated participant you may be required to take all if you take any.

[QDROphile]

It is also possible to roll over a loan directly (not really, but the IRS says it is OK), so you could roll your entire balance to the plan of your new employer, if both plans allow.

[Guest Pecos]

Thank you! I called my prior employers 401(k) administrator and they will allow me to do a partial rollover. I called my current employer's 401(k) administrator and I am eligible to take a loan up to 50% with out any waiting period. Perfect! (well at least I think so....)

[Disco Stu]

Just one other thing to think about...

Loans from 401(k) plans are not always the cheapest borrowing available. Even if the interest rate is low, loan initiation fees from 401(k) plans can sometimes be quite high. Particularly if you're borrowing short term, a large loan initiation fee coupled with possible ongoing loan maintenance fees from your new 401(k) plan could make for a very high cost of borrowing. You might look into other commercial sources for a loan and compare the costs. Make sure you go into this fully informed.

[Guest 410b]

Just one other thing to think about...

Loans from 401(k) plans are not always the cheapest borrowing available. Even if the interest rate is low, loan initiation fees from 401(k) plans can sometimes be quite high. Particularly if you're borrowing short term, a large loan initiation fee coupled with possible ongoing loan maintenance fees from your new 401(k) plan could make for a very high cost of borrowing. You might look into other commercial sources for a loan and compare the costs. Make sure you go into this fully informed.

Yes, but don't you (the 401k participant) get the interest yourself instead of paying it to the bank or other lender and wouldn't that offset the initial costs?

[Disco Stu]

Yes, but don't you (the 401k participant) get the interest yourself instead of paying it to the bank or other lender and wouldn't that offset the initial costs?

While you do “pay yourself interest”, this isn’t necessarily a savings over commercial borrowing. As a hypotherical, let’s compare a 401(k) loan and a commercial loan that have identical interest rates and fees. We’ll pick 6% as the interest rate. To further even the scales, let’s also assume that the participant’s 401(k) account will also earn 6% over the period of the proposed loan.

Whether the loan is taken from the 401(k) account or from a bank, the individual is in exactly the same position after the loan is repaid. This 401(k) balance isn’t any different, he paid the same amount out of pocket for the use of the money, and his taxable income is the same under either scenario. The fact the individual paid the interest into his 401(k) account rather than to a bank doesn't affect the outcome.

In reality 401(k) loans have other risks and pitfalls that commercial loans do not. There’s the risk that the loan would become taxable income (with a 10% penalty) if the individual lost his job and wasn’t able to repay in full. It’s also likely that the 401(k) account would outperform the loan and that the individual will end up with less money at retirement because of the 401(k) loan. Just to name two...

[Guest 410b]

The fact the individual paid the interest into his 401(k) account rather than to a bank doesn't affect the outcome.

The fact that I could keep several thousand dollars of interest rather than leaving it with a bank seemed to me to be a major effect in my personal outcome when I considered a 401(k) loan. I will concede the penalty situation is an issue which some borrowers may dismiss too lightly. I can't assess that accurately because I can't judge another borrower's level of desperation and the penalties do not apply in my situation.

[Disco Stu]

The fact that I could keep several thousand dollars of interest rather than leaving it with a bank seemed to me to be a major effect in my personal outcome when I considered a 401(k) loan.

I suppose if the person in my hypothetical had an irrational dislike of banks he might be swayed away from the commercial loan. Other than that, could you please illustrate the financial difference in the two scenarios in the hypothetical?

[Guest 410b]

Hey,

Thanks for the responses.

I did tell a guest speaker banker in a college class once that I thought the problem with banks and loans was that they would only loan money to people that didn't need to borrow it!

I don't know if there is an assumption difference somewhere or if I have truly been missing all the points.

I'll try to think it through and post back.

[Kimberly S]

I think the part you're missing is that paying yourself 6% instead of paying to the bank may cost you 10-11% (stock market historic returns) that another investment would have earned in that time period in the market. Either way you are paying 6%, but the earnings potential is very different. Of course, 6% interest the past few months looks pretty terrific compared to the market.

[masteff]

Kim posted what I was going to say but in shorter words.

Have to compare the time-value of the loan under both scenarios and that will be influenced by 1) rate of return versus interest rate and 2) plan interest rate versus commercial interest rate. And have to keep Disco's point in mind that some plans have high fees which effectively reduces return under that scenario.

[Disco Stu]

I think that referring to this as “paying yourself interest” is somewhat misleading. Think of it as “reimbursing your account for lost earnings”. If you didn’t take the loan from your 401(k) account, that money would continue to appreciate at whatever rate the market dictated. If you do take the loan, now you’re responsible for funding that market value increase out of your own pocket. Whether you pay interest to the bank or pay it into your 401(k) account, you’re still paying that cost from some after-tax source of funds. If you take out of the equation the fact that equities traditionally outperform fixed income investments, and assume an equal rate of return for the loan and the 401(k) assets, you’ll see that the situation is a wash. There is no benefit to “paying yourself interest”.

[Guest 410b]

Sorry, I have been buried in trying to understand the issues in my other thread.

Of course, 6% interest the past few months looks pretty terrific compared to the market.

And 9% + looks even better compared to the actual returns on my plan; however for purposes of this discussion I am not allowed to consider that.

Ok, I put 5,000, 2 years, weekly payments (104 periods), into Tvalue and got 977.92 in interest. I think I see what you are saying, because if I assume the same compounding assumptions, whatever those are, then I am earning 977.92 in the plan which I get when I retire and paying 977.92 for the use of the money. If I borrow the money from myself, then I am substituting my payments for the plan's income stream. So I have to concede to your logic.

I must be one of those people you referred to who has an irrational dislike of banks, because it was a tremedous psychological struggle to stop thinking about "keeping my money" and hear what you were trying to tell me. Next week I will likely be back to thinking of paying myself again. I had another reason for the loan which I now suspect you would also be able to put the time value of money against in some way and tell me that decision was flawed as well.

At any rate, thanks for the responses.