In last Tuesday’s “What The Fee” post, I wrote about how I despised my 401(k). A couple months back, I decided to do something about it that may strike some as a bit insane. Today I spill the beans. More on that in a moment. First though, it turns out that I owe my 401(k) a little bit of an apology.
- The $500 annual fee that I complained about is actually paid by my company. Big thanks to DoneByForty for pointing this out.
- I have some really horrible funds in my portfolio and I was investing in them. A couple of them charge almost 2% in fees. However, not all of my choices are that bad. Many are below 1% including Fidelity’s Contra which Jim Collins pointed out isn’t terrible at .74%. I have since moved most of my money to Contra and some of the other lower fee options. Again, part of the problem was mine in that I didn’t do my research and had my money in high fee funds. If you haven’t already, check out Mr. Collin’s excellent write-up on 401ks.
I do wish that my 401(k) had more options from Vanguard. They have only one and it’s a bond fund which doesn’t really get me going.
What I tried to do and what I did
In last week’s post, I described how I tried to get my employer to let me quit so that I could roll my 200K over into something else. My plan was to quit, roll my money over and then be rehired. My boss thought I was a bit nuts. I tried explaining how I didn’t like the 401k and the reasons, but it went over his head. There were also a bunch of logistical issues that made my scheme a bad idea.
My next course of action was to see if they had a self-directed plan. I had one of these at a previous company and thought it was great*. With a self-directed plan, your 401k becomes more like an eTrade account, allowing you to invest in whatever you wanted. The answer to this was also a big “No!”
The idea that I came up with was to take out a 401k loan and invest the money myself. The maximum loan with a 401k is $50,000 which is only 25% of my holdings, but better than nothing. Before you label me as a nut, allow me to address a couple issues regarding 401k loans. Two big reasons are often thrown out there for not taking out a loan:
- If I lose my job or quit, I’ll have to pay the money back or incur a big tax penalty. This is not an issue since I have enough cash to cover the loan.
- The loaned money is not working for you. If I have a loan balance of 50K, that is money not participating in the markets. Over the course of a 5 year loan, that could add up to a big chunk of change. However, since I am investing the money myself, this is also a moot issue.
So, I did just that. Earlier this year, I took out a 401k loan. I haven’t quite decided yet where to put it all**, but the wise thing to do would be a Vanguard index fund or two since this is where my 401k money should be in the first place. I may throw a little bit Warren Buffett’s way as well.
Would you do the same in my situation? If so, where would you put the money?
*The self-directed plan actually turned out to be not so great. It was the late ’90s and I got caught up in the Internet hype, losing my pants in a variety of ridiculous investments. I would certainly invest these funds much more conservatively if I had the opportunity now.
**Since this money is borrowed, I’m not counting it towards my nest egg on the right side of this page.
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What are the tax implications of this scheme uh I mean plan? 😉
Also thanks for last week’s info on Peraonal Capital – it is my new favorite website. It was a relief to see that my fees are quite low. I also used the allocation tool and rebalanced a few things.
No tax implications unless I quit and don’t pay it back. Then, I’d have to pay a 10% penalty above the income taxes that I’d also have to pay.
Glad you like Personal Capital. It is great, isn’t it?
No, I actually think there ARE tax implications. The funds that WERE sitting in your 401k (free from taxation for dividends/capital gains) are now in a taxable account (subject to those taxes). I haven’t run the math at all, but I’d highly doubt that the decreased fees will make up for the larger tax hit you’ll be taking.
Here’s a better idea: ask your boss about switching the 401k provider. Point out the math/benefits to him/her, and maybe even do the leg work to show how much better running the 401k through Vanguard (or Fidelity, or really anyone with better options) would be for you, the company, and all the other employees.
“No, I actually think there ARE tax implications. The funds that WERE sitting in your 401k (free from taxation for dividends/capital gains) are now in a taxable account (subject to those taxes). I haven’t run the math at all, but I’d highly doubt that the decreased fees will make up for the larger tax hit you’ll be taking.”
True, I’ll have to pay taxes on any dividends, but that is about it. That will be minimal though. I don’t plan on cashing out any investments for a long time.
I work for a massive corporation. I’d love to see them make a change, but I just don’t think it’s going to happen.
Done by Forty says
Thanks for the kind words and the linkback! I have to admit I have no experience in 401k loans, other than hearing how my family members use them…
If you invest the money outside of the 401k, aren’t the gains going to be subject to short term & long term capital gains tax? It’s certainly possible that you could still come out ahead due to better investment options, but run the numbers, just to be sure.
A lot will depend on whether you guys can squeak into the 15% marginal tax bracket or not (thereby avoiding capital gains). My guess though, since capital gains are 15% long term and potentially much higher short term, is that you may be better off just sticking with the Fidelity fund w/ the .74% expense ratio and calling it a day.
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Yes, you’re correct about the tax situation. The way I look at it is that my money will be taxes either way. When I’m old and grey and pull my money out of the 401k, I’ll pay taxes on it just as I will with the after tax investments.
Yeah, I may have been better off leaving the money in there. In the long run, I’m not convinced it will make much of a difference. In 5 years, the loan will be completely paid back.
Another factor that I did not realize when I took out a 401k loan was this…….that money goes into the account tax free but when you pay the loan back you are paying it back with money that is taxed. In my case they (Fidelity for my company) somehow kept that money separate so when I rolled it all out at retirement I was able to put that portion into a ROTH and the remainder into a traditional IRA. In this scenario they said that was only available since I was taking ALL the funds. If I was doing a partial rollover I would be taxed yet again for that money.
Interesting, I’ll have to see if mine does this.
If you get yearly reports, etc look for before and after tax columns…as you pay the loan back it should change….plus you have lost that money that you had deposited tax free.
Judging by the amount of research you’ve done so far, I’d imagine you’ve already looked into this, but does your company offer a Roth 401(k) plan?
With a Roth, there is no penalty for withdrawing your deposits, so in theory you could get your company match and then just withdraw it and do with it what you please. In reality, I think there are certain limits like how many withdrawls a year, etc.
Yes, they used to offer a Roth and then they took it away! Grrrrrrrrrrrrr!!!
Vanguard index funds rule. period.
I love it.
1500!!! Thanks so much for writing this post. I’ll explain in a sec. First, however, good for you having the balls to even suggest to the boss the fire/rehire plan. Amazing! And thanks for mentioning Vanguard again, especially their index funds. Ramit Sethi got us on the right track last year and we transferred our IRAs from Pac Life (Holy crap, they suck!) to Vanguard. And now we are interested in investing and I see these nice tid-bits about their index funds! Totally stokes me off!
Have a hedge hog of a Wednesday!!
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I have been a Vanguard member for many many years.
I researched funds and arrived at a scientifically selected group of index funds, large and small cap, REITS, Various Bond funds, etc….about 10 of them.
Once I rolled over ALL my company IRA’s, pensions, etc to Vanguard I had a large enough pile of $$$ that they gave me my own investment advisor. He showed me how with just 3 funds I could have the same coverage as all those funds and save several thousand a year in fees.
VBTLX Vanguard Total Bond Market Index Fund Admiral Shares 0.10% fee
VTIAX Vanguard Total International Stock Index Fund Admiral Shares 0.16% fee
VTSAX Vanguard Total Stock Market Index Fund Admiral Shares
I know that this sounds too easy but do your research and stay away from the “money” magazines and “mad men” on TV and you will retire like I have without a care…financially.
This is great information and much appreciated. Thank you.
“I know that this sounds too easy but do your research and stay away from the “money” magazines and “mad men” on TV and you will retire like I have without a care…financially.”
Could. Not. Agree. More. The financial media is horrible. If they told the truth, there would be nothing to write about. So, we get drivel about timing the markets and similar nonsense.
I’m with you, Wayne. I recently overhauled my entire portfolio (over 34 different holdings) down to 4: VTSAX, VTIAX, VBTLX, and a little sprinkle of VTABX (Int’l Bond fund) for additional diversification.
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I didn’t know the international bond fund was available yet……I was advised to make that about 10-20% of my bond holdings….. will check it today. Thanks.
JC @ Passive-Income-Pursuit says
If I didn’t enjoy researching companies and wanting to go the individual stock route, Vanguard index funds would be my next stop. I have my rollover IRA there and a Roth IRA as well. The funds usually have some of the best, i.e. lowest, expenses and if you’re buying index funds you want those as low as possible. History has shown that very few funds can continually beat the market, so why go with an active fund manager who has to beat the market by at least the expense ratio just for you to breakeven with the market?
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Yep, completely agreed. I think it will be Vanguard all the way.
John S @ Frugal Rules says
Very interesting strategy and sad it’s one you had to take. It just drives me nuts when employers offer overall crappy plans. It would be so much easier to offer a plan that was chock full of some decent index funds and even a few others in case that’s not your speed. I know it might not be for everyone, but I am all for a self-directed 401k.
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Man, I would give parts of my body to have a self-directed 401k.
Mrs PoP @ Planting Our Pennies says
My curiosity would be over the AC situation as well. It would seem like you’re going to be double taxed on the money… When you cash it out to pay back the loan (or at regular income tax rates if the pay-back happens as a below tax line on your pay stub), and then taxed again when you pull the money out of your 401K later? Just not sure I would be willing to risk the tax man confusion when I could just buy a cheap SP500 Fund and another cheap bond fund in the 401K and be done with it. The fees might be marginally higher than vanguard ones, but I don’t plan on staying at my job forever, so I’d roll over to a Vanguard IRA as soon as I could anyhow.
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Mrs PoP @ Planting Our Pennies says
Silly auto correct! I meant tax situation not AC! =)
Mrs PoP @ Planting Our Pennies recently posted…DIY – Strip Wax Off Linoleum Flooring
I’ve thought over the tax situation and I think it’s a non-issue: My loan comes tax-free since it’s a loan. Any money I invest from that loan will have the same tax implications as money in the 401k itself. When I sell either investment, I’ll pay taxes at that time.
I do pay the loan back with after-tax income. However, if I just didn’t take the loan in the first place and invested 50K in after tax income, I think the end result is the same. The only difference is what the 50K is invested in in the meantime.
Let me know if I’m missing something here.
Mrs. Pop @ Planting Our Pennies says
I guess I was thinking if you had to sell the investment to pay back the loan (since you can’t really just move shares in/out of a 401K), you’d pay tax then on that sale and then again when you withdrew it from the 401K years later. But if you’re just repaying it out of cash flow, you’re probably right that it’d be roughly equivalent.
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Being a CPA, I don’t agree with what you are doing. You’re subjecting yourself to double taxation. You’re paying the loan back with after tax money. Also the interest that you are paying on the loan (most I’ve seen are in the 4% to 6% range) is with after tax money and then when you pull it out, it’s taxed. Also the interest might or might not be deductible (you might try to classify it as margin interest, but that’s another long discussion). With this double taxation (paying back the loan and interest with after tax money and then being taxed when you pull the money out), I think that you are going to lose out on money by doing this just to save a small percentage on your fees. If you stay at the job for another 30 years, you might come out slightly ahead. Sorry for raining on your parade and being a Debbie Downer.
I don’t know if you’re thinking about the whole picture. You are correct in that I’m double taxed on the loan payback, just like I would be if I invested my after tax paycheck money.
However, you’re not taking the loan itself into account. That money comes at me tax free and I’m investing it. Just like the 401k, I’ll only pay taxes on it when I cash my investments in.
If you think about it this way, I’ve just swapped money.
Net Worth Snowball says
It’s pretty frightening how much hard-earned money must be squandered in atrocious fund options with such high fees. Like CJ said, I admire that you had the cajones to propose the whole fire/rollover/re-hire scheme.
For the first 3 years of employment I only contributed up to the match amount due to an unappetizing buffet of fund options above 1% fees. So I missed out on plunking down around $25k into the 401(k) during the timeframe when the DJIA ranged between 7,000-10,000 🙁
We now finally have an index option with an S&P index with ~0.07% fees so I now pony up the full contribution.
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Glad to see that you have decent investment options now, but what a bummer missing out on that bull run. The past 5 years have been nuts.
Pretired Nick says
I don’t know. At some point the hassle doesn’t really seem worth the money. Guess you might have the last laugh, though!
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Agreed about the hassle. I often make things way more complicated than they need to be. Not just finances, but home remodels, car repair, etc.
“Basically as a ploy to contribute more to the 401k than they could otherwise”
Ha, I thought of this too! The long term result is I may actually end up with more money in the 401k than I would have had otherwise, especially if the markets have a bad year or two.
Tammy R says
Hi Mr. 1500. I don’t know what I’d do, but I do know that I laughed myself almost clear off the couch that you tried to get fired. I think that you are very secure in your job which makes me very happy because you are clearly a nice man.
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No Waste says
I have to admit I didn’t see that coming.
Everything I’ve ever read has said to never take a loan out from your 401(k).
But then again, everything I’ve ever read said to avoid whole life insurance…and I still bought some!
Sometimes you just gotta’ do what’s right for you.
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