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The Broken 401(k) Solution

Over 5 years ago, I wrote Fixing the 401(k) loan. It was in response to the number 1 reason to avoid the loan, the fact that it’s a risk. One day, you are working, paying all your bills, funding your 401(k), and doing it all right. The loan was to clean up the 18% credit card that was a result of medical bills, and you had no choice. Better to pay yourself, than to pay 18% for years. The risk of course is that if you lose your job, the loan is called in. If you don’t pay it back, it’s deemed a withdrawal, and you have taxes as well as a 10% penalty due. Ouch. This is why the 401(k) loan is frowned upon. Even if you just change jobs, you may not easily get the new 401(k) set up and move enough from the old account in time to borrow from the new account to pay the old. Just thinking about this give me heartburn.

Recently, I’ve been giving great thought to this. Not because I had a loan, but because my wife and I are retired. We’ve done very well using the advice that I offered readers in The 15% solution, a recommendation to strive to keep one’s tax bracket from creeping higher than 15% by strategically taking advantage of pre-tax retirement accounts while working. Now, retired, it’s a matter of throttling withdrawals to straddle the 15/25% line. Our budget has been fine these five years, but I’ll admit, we’d probably go over if we hit a very large expense, such as the new roof I’m anticipating. With other factors such as a rental property, the 15% bracket and 25% bracket aren’t precise. 15% results in about 20% of the last $10K as tax, and the 25%, closer to 29% of the next $10K. To keep it simple, let’s call it a 10% hit for going over.

As I pondered this, the light bulb moment came. I have Schedule C income, and therefore I was able to open a Solo 401(k). With just part time income, it’s not a large balance. However, I can transfer funds from my old job’s 401(k) or my IRA to this account. And the Solo 401(k) permits a loan, same rules as my old employer’s 401(k). I can borrow up to $50K or 50% of the account balance, whichever is lower. The interest is negotiable, typically, prime or a bit higher. My wife can follow the same strategy, offering us a combined $100K of accessible funds.

For the retiree, I can think of another important benefit. As I wrote about in the article The Phantom Couple’s Tax Rate Zone, a couple taking Social Security benefits can think they are in the 15% bracket, but the next $1000 of IRA withdrawal causes more SS money to be taxed. So, instead, they pay $275 on the next thousand (or $2750 on the next $10K). Obviously, they can’t do this each and every year. This strategy is for a one-time, or once every few years, event. It’s a cheap way of shifting taxable income out by a year or averaging it over the next couple years.

When I discussed how to beat the standard deduction, I shared a strategy that I used by year end. I’ll walk you through it now. As retirees, we pay our own health insurance premium. Normally, it’s not deductible as it’s just about 10% of our annual income. I wondered what the impact would be if I just paid ahead, paying the 2017 premiums in December 2016. I checked to be sure that prepaid premiums were deductible, and saw they are. I already had the 2016 tax software, and saw that it worked just fine, I’d see a combined 20% refund on the extra premium. Which immediately let me bump our withdrawal to again top off the 15% bracket making the benefit a full 30%, including our state tax. I offer this anecdote as part of this post for one reason. If I didn’t want to take a larger withdrawal and didn’t have the funds to pre pay the insurance, the 401(k) loan would have been my backup. Say my premium was $10K. The average of all 12 payments is mid-year, making my 20% benefit not a 20% annualized return, but more like 40%. The full $10K, along with just $500 or so in interest goes back into the 401(k), and you are still $2500 better off.

One last example of the beauty of the Solo 401(k). You have an IRA, which is valued at $100K, but includes $50K of non-deducted deposits. This could be for any reason, but likely because you started a job some time ago that offers a 401(k). Now, if you were to convert this whole IRA to a Roth, you’d be subject to tax on $50K, the portion that was deducted from income. If only there were a way to convert just the non-deducted $50K, so it could grow for decades, tax free. There is. You arrange a transfer of the $50K into your Solo 401(k). This leaves the remaining $50K with a $50K basis, and the Roth conversion is tax free. 8%/yr for 30+ years and this money should double 4 times to over $400K, only now, it’s tax free.

There’s a lot here to absorb. As you can see, the Solo 401(k) adds to the flexibility of your retirement investing, whether or not you take advantage of the loan provision. If you have any questions about any strategy I mentioned here, please drop a comment. Have you been caught with a 401(k) loan while changing jobs or getting let go from your job? Share your story with my readers.



  • Antonio November 2, 2017, 1:58 pm

    Great article Joe! Indeed there is a lot of info to absorb that I’m still sifting through it. I have a similar situation, stuck with a $3,200 401k loan at 3.5-4% interest. I am trying to pay it off sooner than later but its tough… Would your a solo 401k loan route? or just try to pay it off? I like where I am employed and not switching jobs or anything. Thanks for any insight/suggestions!

  • Joe November 3, 2017, 9:26 am

    If you have self-employment income to justify creating the Solo 401(k), it would help you stretch the terms of the payments, a new 5 year amortization. For such a small amount, I’d tighten my belt, and find the extra money to aggressively pay this off.

  • Antonio November 3, 2017, 9:29 am

    Thanks for the info and motivation Joe! Yes, it might be a small amount to some people but I do not make that much so its difficult for me! However, I want to get rid of this loan to make room for smart investments!

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