Borrow to fully fund retirement accounts?
rev...@linuxwaves.com
accounts. Right now, we fully fund my account, but we don't have the
extra cash to fund hers.
But we do have equity in our home.
Is there any reason not to borrow the funds, in the form of a HELOC, in
order to maximize contributions to a 401K or 403(b) retirement
accounts?
We would get tax deduction for the contribution; the HELOC interest
would be deductible. And in the long term, the growth in the
stock-invested retirement accounts should beat the HELOC interest.
Of course we have to afford to carry the HELOC, and we would eventually
have to pay it off--but that could be years away when we expect our
incomes to be higher.
Are there risks I am missing? Why isn't this a no-brainer for anyone
confident they can carry the loan?
Thanks.
Elizabeth Richardson
> Is there any reason not to borrow the funds, in the form of a HELOC, in
> order to maximize contributions to a 401K or 403(b) retirement
> accounts?
>
If you can afford to pay additional mortgage payments via a HELOC, why can't
you just divert that money into her 401k? I mean, why would you want to pay
money to the bank instead of to yourself?
Elizabeth Richardson
rev...@linuxwaves.com
>why can't you just divert that money into her 401k? I mean, why would
>you want to pay money to the bank instead of to yourself?
Because the HELOC interest (at 6.5%) on $15K contribution is only $975
per year. We can afford that. We can't afford another $15K beyond what
we are already putting away.
Moreover, by making the full $15K contribution, we save about $4000 in
income taxes.
Of course, we now have $15K less equity in our home, but an equivalent
amount now sits in her retirement account--growing at a faster rate
than the HELOC interest if past history is a guide.
Effectively, we have transferred equity from our home into her
retirement account, taking advantage of the tax deduction in the
process.
It seems obvious to me. Am I missing somthing?
he...@sagetips.com
Some things I would consider:
1. Is there an employer match? If so, a 50% or 100% match makes it
clos to a no-brainer. I see people pass on employer matches everyday
because they don't feel they have the money. In these cases, a well
thought HELOC advance can make a lot of sense.
2. Do you have cashflow to pay the debt off relatively soon? I
wouldn't make interest-only payments for 5 years or anything. I'd pay
it off as if it were a short-term obligation with a fixed amortization
schedule. If you plan to sell the house in the near-term, this should
be a consideration too.
3. How close to retirement are you? The strategy is a good one for
people in their 50's to help fund "catch-up" contributions.
4. How much equity do you have and are you well-situated for
"emergencies". If you have 3-6 months emergency reserve cash sitting
in a 3% savings account, consider using it for the 401k and keepng the
HELOC untapped for emergencies. You lose 3% earnings, but avoid 6.75%
interest (say 4.85 after tax).
5. How confident are you that you can beat the after-tax interest rate
on the loan, particularly in a rising rate environment?
You could add another twist too (if you're very careful) - borrow on
the HELOC to make the 401k contribution and then transfer the HELOC
balance to a credit card through one of the (seemingly disappearing) 0%
balance transfer offers. Gotta be careful though and consider possible
impact on FICO.
rev...@linuxwaves.com wrote:
rev...@linuxwaves.com
> 1. Is there an employer match? If so, a 50% or 100% match makes it
> clos to a no-brainer.
I have a match, but my wife does not. That's why we funded mine first.
> 2. Do you have cashflow to pay the debt off relatively soon? I
> wouldn't make interest-only payments for 5 years or anything. I'd pay
> it off as if it were a short-term obligation with a fixed amortization
> schedule. If you plan to sell the house in the near-term, this should
> be a consideration too.
Probably, if we stopped making maximum retirement contributions. But
why
is this necessary as long as we are comfortable with the HELOC
payments?
Our house is appreciating faster than $15K per year, so even if we did
this year after year, our LTV is still decreasing. We could always
refinance and just pay off the loan.
>
> 3. How close to retirement are you? The strategy is a good one for
> people in their 50's to help fund "catch-up" contributions.
>
We are 45 are 46.
> 4. How much equity do you have and are you well-situated for
> "emergencies". If you have 3-6 months emergency reserve cash sitting
> in a 3% savings account, consider using it for the 401k and keepng the
> HELOC untapped for emergencies. You lose 3% earnings, but avoid 6.75%
> interest (say 4.85 after tax).
>
I'm guessing we have about $150K in equity, if we got the house
reappraised.
> 5. How confident are you that you can beat the after-tax interest rate
> on the loan, particularly in a rising rate environment?
>
Not at all in the short term. But I'm very confident in the long term.
(Of course, as the economist pointed out, we are all dead in the long
term.)
> You could add another twist too (if you're very careful) - borrow on
> the HELOC to make the 401k contribution and then transfer the HELOC
> balance to a credit card through one of the (seemingly disappearing) 0%
> balance transfer offers. Gotta be careful though and consider possible
> impact on FICO.
>
Yeah, I know. I think that's riskier than what I am proposing.
...
I still don't understand why financial advisors don't recommend that
anyone with significant home equity--but not enough salary to fully
fund
all retirement accounts--do this. One is simply transfering home
equity into your retirement account, while making a profit equal to
your tax rate.
>
> rev...@linuxwaves.com wrote:
HW "Skip" Weldon
>I still don't understand why financial advisors don't recommend that
>anyone with significant home equity--but not enough salary to fully
>fund all retirement accounts--do this. One is simply transfering home
>equity into your retirement account, while making a profit equal to
>your tax rate.
Assuming debt rates don't continue to rise and your retirement plan
has diversified, low-cost investment choices, there's nothing
categorically wrong with your idea.
As for why it isn't widely recommended, my view is that no new wealth
is being created - we're merely moving money around. In my experience
financial security comes from *how much* we save, not where. And your
idea saves no new money.
It reminds me of moving debt from one card to another to get a lower
rate - we still have the debt. Our net worth is unchanged.
So I would prefer a focus on how one can contribute to their
retirement plan with NEW money. (Hint: It involves spending less and
saving regularly, not creative quick fixes.)
As for the tax rate profit from deducting the contribution - I'd
hesitate to call it "profit". The tax saving is deferred, not free.
You'll pay it back later.
-HW "Skip" Weldon
Columbia, SC
rev...@linuxwaves.com
Yes, I should not have called it "profit." However, I can think of
several reasons why you would end up with more total equity/money
at retirement by borrowing to fully fund your account.
1. You might end up in a lower tax rate at retirement, in which case
the original tax deduction would be a profit.
2. In the long-run, diversified investment in stocks should grow faster
than the (tax-deductible) Heloc interest.
3. Home equity counts against parents available assets for
college aid calculations, but retirement accounts don't. You might
end up with more college aid with this approach.
4. In case of bankruptcy, creditors can take your house, but they
can't
take your retirement accounts.
Finally, many people may not be maximizing their retirement
contributions, because they are afraid they may need those funds
sometime during th year. If they have a good line of credit, however,
they could go ahead and sign up for maximum retirement contributions.
If they need the money, they can draw on their line of credit;
if they don't, or if they pay down the line later,
they have contributed (and saved) more than they would have.
This works to encourage more savings as long as people don't abuse the
line
of credit by drawing out more than they contribute! (But I'm talking
about
disciplined people here.)
Paul Michael Brown
> anyone with significant home equity--but not enough salary to fully
> fund all retirement accounts--do this. One is simply transfering home
> equity into your retirement account, while making a profit equal to
> your tax rate.
In order for this to work, the rate of return on the borrowed contribution
to the retirement account has to exceed the cost of borrowing the money.
Several things occur to me. In no particular order:
1. Time Horizon. The poster and his wife are 45/46 years old. If they
intend to retire "early" they might have only 10 years to make this work.
In my view, assuming the ROI on equities will beat the cost of the
mortgage loan over a decade is not totally outrageous. But it's not a lead
pipe cinch either. I'd feel better if the poster and his wife had a 20
year time horizon.
2. Interest Rate Risk. I would definitely be leery of any type of variable
rate mortage, HELOC, or whatever. Google Stephen Roach's latest prediction
that the capital markets will be roiled when Greenspan retires Jan. 31.
Look at the hawkish comments from Fed Gov. Miller last week re the
inflation "virus." Consider Citigroup's call last week that Fed Funds will
go to at least 4.5 percent. And Google "inverted yield curve." In other
words, never fight the Fed. If you're going to do this, you'll need a
fixed rate mortgage. Problem there is the rate is higher and it's less
certain your ROI in the retirement account will exceed the cost of
borrowing. As the old saying goes, there is no free lunch.
3. Taxes. You're correct to consider the after-tax cost of the borrowed
money secured by a mortgage. But don't forget that withdrawals from the
retirement account will be taxed at ordinary income. Granted, the returns
will accumulate tax-deferred. But that's not the same as tax free. I think
that in order to make a fair comparison, you have to reduce the ROI on the
retirment account by about one-third to account for the taxes you will
eventually have to pay. If you do that, it gets WAY harder to assume that
the ROI on the retirement account will beat the interest rate on the
borrowed money. Finally, consider that a long term capital gain on the
house gets a $500K exemption and a favorable rate after that. (At least
under current law.) Moreover, the house can be a good asset-planning tool
because if the heirs inherit it they get the stepped-up basis.
Call me old fashioned, but I like the idea of heading into retirement with
a paid-for house. And in today's competitive mortgage lending world, it
will always be easy to tap that equity if need be. So I concur with Skip
that the best approach here is to save more out of cash flow rather than
borrowing the funds. Leave the carry trade to the hedge fund wizards.
rev...@linuxwaves.com
Paul Michael Brown wrote:
> 1. Time Horizon. The poster and his wife are 45/46 years old. If they
> intend to retire "early" they might have only 10 years to make this work.
We won't retire for 20 years.
>
> 2. Interest Rate Risk. I would definitely be leery of any type of variable
> rate mortage, HELOC, or whatever. Google Stephen Roach's latest prediction
>
Has there ever been a 20 year period where stock market did not beat
prime
rate?
>
> 3. Taxes. You're correct to consider the after-tax cost of the borrowed
> money secured by a mortgage. But don't forget that withdrawals from the
> retirement account will be taxed at ordinary income.
You win if you are in a lower bracket at retirement. But even
if you are in same bracket, ROI would be positive as long
as long-term stock market beats averaged prime rate.
> Finally, consider that a long term capital gain on the
> house gets a $500K exemption and a favorable rate after that.
You still get the gain on the house. I don't see how this changes
anything.
> Call me old fashioned, but I like the idea of heading into retirement with
> a paid-for house.
I like the idea of having more total funds+equity at retirement.
Paul Michael Brown
Borrowing at the "prime rate" to fund the 401(k) contribution requires
taking out a variable rate loan for 20 years. In my view, that creates a
VERY large risk if short term interest rates go up. (And let's not forget
that short rates are LOTS more volatile than long rates.) Take a look at
http://research.stlouisfed.org/fred2/data/PRIME.txt and you'll see some
truly scary numbers in the late 70s to mid 80s.
Moreover, this scenario requires borrowing $15K per year every year for
the next few years, then even more if the spouse wants to make catch-up
contributions at age 50. A decade from now, the total amount borrowed
might approach $200K. Even a small increase in the rate paid on the second
mortgage would drastically increase the carrying costs. What if the value
of the home securing this debt level offs, or even falls? What if there is
a catastrophic loss not fully covered by insurance? There is the risk of
foreclosure.
> You win if you are in a lower bracket at retirement. But even
> if you are in same bracket, ROI would be positive as long
> as long-term stock market beats averaged prime rate.
Surf over to
http://financialcounsel.com/Articles/Investment/ARTINV0000196-Regression.asp,
which explains:
"Between 1971 and 2003 annual returns of the Wilshire 5000 Index ranged
from a high of 38.5% to a low of -28.4% . . . . The Wilshire 5000 Index
had 24 positive annual returns and 9 negative returns during the 33 year
period. Thus, this particular U.S. equity index reported a positive return
about 73% of the time. The average positive return was 22.3% and the
average negative return was -11.4%. An interesting observation visible in
Figure 2 is how seldom the annual returns were anywhere close to the 33
year mean return of 11.6%. In fact, over the 33 year period there were
only 3 years in which the return was within 300 basis points of the mean
return (1978, 1992, 1993). Thus, even though the fluctuating annual
returns demonstrate a phenomenon known as "regression to the mean" it is
clearly the case that such regression seldom produces mean-level returns
in any given year. It is more accurate to think of regression to the mean
as "a-change-in-direction-toward-the-mean-sooner-or-later", rather than a
guiding force that produces mean-level returns on an annual basis.
Regression to the mean tends to produce a pendulum effect that causes
year-to-year equity returns to swing above and below the mean return,
sometimes significantly so. "
Suppose we have a string of years like we did in the 70s when the prime
rate was in double digits and the stock market was going DOWN? (Caused, in
large part, by a sharp rise in oil prices. But that's not a problem we
face today, right?) Do you have the stomach to borrow another $15K every
year and then watch it evaporate in the equity market? What do you say to
your wife every fourth year when you borrow money against the old
homestead and it disappears? "The principal is gone. We still owe the
interest. But our retirement looks secure!"
Everybody CLAIMS they can stay the course over the long term in the equity
markets, but study after study shows that most investors do not. They get
scared of losses (or psyched by gains) and they make stupid market timing
decisions.
As for being in a lower tax bracket post-retirement, that's fine. But
you'll still have all that mortgage debt, and the interest deduction will
be worth less.
Tad Borek
> Has there ever been a 20 year period where stock market did not beat
> prime rate?
I agree w/Paul, there's a risk with the variable rate of the HELOC. Sure
the 20-year prospects look good, but you might not be able to ride out
20 years because a turn in rates "flushed you out". Especially if it
came at a bad time - eg job loss. This is basically the hitch with
margin investing generally, it looks great until those odd events hit.
Borrow-equity-to-invest scenarios look better when the interest rate is
fixed (especially at these historical lows), and income is sufficient to
make THAT payment. You're still earning money just at the margins
(difference between investment earnings & borrowing costs), but with all
the tax benefits factored in it's more likely to work. Of course in
these scenarios you can't do more than make educated guesses, because
nobody knows what future tax rates & structures will be.
I could see a HELOC if you expected a bump in income, a bonus, or an
inheritance in a short time period, at which point you could pay it off.
Otherwise this kind of borrowing might be better left for a time when
cash flow is stronger, or even until retirement - when you can borrow
out the equity to spend it, rather than borrowing it now, ekeing out the
marginal returns (above your cost of borrowing), and assuming the risk
of dramatically higher HELOC rates along the way.
Another risk to consider is a drop in income along the way...not just
job loss but something more permanent. Some people would choose to
insure against that (disability insurance).
It is funny though how the way you frame the question can make this look
much more palatable. Imagine you posted saying "I just bought a house, I
can either get a 15 year mortgage and reduce my retirement plan
contributions by $12k a year, or a 30 year and keep the $12k
contributions, which should I do?" Probably most replies would be to
take the 30-year. It's essentially the same question - that trade-off
between the rate at which you add home equity, and the rate at which you
accumulate accessible investment assets. Only in your scenario it's a
decision made during ownership rather than at purchase.
-Tad
jIM
step. I wouldn't add debt just to "invest more" than $15,000.
How much income do you have? I ask because if income is less than
$150,000, you are saving more than 10% of what you make and this is a
good guideline to building wealth.
Regardless of how much money you make, I would second Skip's comments
that borrowing to fund a retirement account involves risk. The primary
risk is the abiliuty to pay off the debt, the second risk the return on
the investment. In addition Skip mentioned to find a way to cut
current debt and save more without borrowing any money. I think long
term, this technique will show significant benefit.
It appears the goal of this technique the tax benefits. Tax break for
401k contributions and tax break for HELOC interest deduction. Are you
more concerned with current lack of saving, or more concerned with
taxes?
Bucky
> Is there any reason not to borrow the funds, in the form of a HELOC, in
> order to maximize contributions to a 401K or 403(b) retirement
> accounts?
Intriguing question! After taking into consideration all the tax
benefits, I think it basically comes down to if the return in the 401K
will exceed the tax-adjusted HELOC interest. On paper, based on
history, it looks like it will work. Stock market annualized returns
are approx 10%. Prime rate average about 8-9%, so after tax would be
around 6-7%.
http://www.federalreserve.gov/releases/h15/data/a/prime.txt
> Are there risks I am missing? Why isn't this a no-brainer for anyone
> confident they can carry the loan?
Despite the paper numbers, I don't think it's a no brainer. How much
were you planning on borrowing on the HELOC each year, $15K? You could
run out of home equity after a few years! I think the biggest problem
is paying back the HELOC. You can't take it out of the 401K (without
penalty). You say your income will be higher, but how can you pay back
$100K?
Andy
>
> Is there any reason not to borrow the funds, in the form of a HELOC, in
> order to maximize contributions to a 401K or 403(b) retirement
> accounts?
> Are there risks I am missing? Why isn't this a no-brainer for anyone
> confident they can carry the loan?
What your strategy does is make your finances more unstable (less
resilient in the event of negative events) in exchange for a potential
greater return if everything goes well.
If everything goes as planned (prime rate stays low, stock market posts
an average return of 10% over the next 20 years, your incomes keep
rising, and you don't incur any unexpected expenses) then your idea
should put a little extra money in your pocket. However, if any one of
those assumptions doesn't work out then your strategy will result in
you having bigger problems than you would have had otherwise. If you
have a drop in income (disability, long unemployment, whatever) or you
incur unexpected large expenses (medical bills, a child or spouse
needing long term care) then the extra HELOC payments will drag you
down and perhaps make the difference between losing or keeping your
home, bankruptcy, etc. Sure you could pull money out of your 401, but
then you would pay taxes and penalties. If the prime rate shoots up
and/or the stock market flattens out or declines, your strategy could
end up costing you a lot of money and/or precipitating a collapse of
your finances (depending on how high interest rates go, etc.).
Of course its up to you whether you want to maximize your potential
payoff at the expense of stability in adverse circumstances. I just
want to point out that there is a cost to this strategy.
On a side note, I feel obliged, as usual, to point out that you can't
assume the stock market will perform forever like it has in the past.
The Japanese stock market hit its peak in 1989 (39,000) and now 16
years later its at 13,500, about one third of what it was at the peak.
Of course we all know that can't happen to the US stock market
because.....well, how do we know that? Because we are Americans and bad
things only happen to other countries? You know that before 1989
everyone in Japan thought that their stock market could never go into a
permanent decline.
Andy
rev...@linuxwaves.com
Obviously the stock market goes both up and down, so this strategy
involves risk just
like any other investment.
However, I think the main benefit is psychological. We probably could
put more
into 401K savings than we do, but we have been afraid we MIGHT need
the cash flow later in the year.
By going ahead and signing up for the IRS maximum--with the knowledge
that
we could always supplement our reduced take-home pay by writing
ourselves a HELOC check--we will probably end up actually saving more;
some months we won't need to write that check at all, so the
extra contributions will be real. And if we get a windfall, we might
just pay down
the HELOC rather than spending or putting in a taxable account. That
would
effectively increase our real deferred 401K savings too.
revheck
Bucky
> We probably could put more
> into 401K savings than we do, but we have been afraid we MIGHT need
> the cash flow later in the year.
Have you maxed out your Roth IRA? $8000/yr for a couple. You can
withdraw the principal/contributions at any time without penalty.
anoop
> On a side note, I feel obliged, as usual, to point out that you can't
> assume the stock market will perform forever like it has in the past.
> The Japanese stock market hit its peak in 1989 (39,000) and now 16
> years later its at 13,500, about one third of what it was at the peak.
> Of course we all know that can't happen to the US stock market
> because.....well, how do we know that? Because we are Americans and bad
> things only happen to other countries? You know that before 1989
> everyone in Japan thought that their stock market could never go into a
> permanent decline.
The bulk of my retirement portfolio is currently in stock (401K, IRA)
with < 5% in i-bonds. When I read things like these I worry. :-)
I (think) I have about 25 years or so before I need these funds.
Would you mind sharing what kind of asset allocation you use?
Anoop
jIM
no more than 5% as well. The one true bond fund I own is emerging
markets bonds, and I hold it because it returns well (I admit, I was
chasing returns when I bought it 4 years ago). I have been buying some
of it each month since, but I purchase significantly more equity funds
with my Roth IRA and 401k purchases.
Elle
allocation"?
I always thought that one's "bond allocation" was to include only investment
grade bonds, per many sources.
EM bonds are on the risky side. Nothing wrong with holding them as part of a
diverse portfolio, but I wouldn't count it as conservative.
"jIM" <norepl...@hotmail.com> wrote
Will Trice
Paul Michael Brown wrote:
>>Has there ever been a 20 year period where the
>>stock market did not beat prime rate?
>
>
> Borrowing at the "prime rate" to fund the 401(k) contribution requires
> taking out a variable rate loan for 20 years. In my view, that creates a
> VERY large risk if short term interest rates go up. (And let's not forget
> that short rates are LOTS more volatile than long rates.) Take a look at
> http://research.stlouisfed.org/fred2/data/PRIME.txt and you'll see some
> truly scary numbers in the late 70s to mid 80s.
Using this data and adding it to Robert Shiller's spreadsheet (thanks
again to Beliavsky for this reference - I've played a lot of games with
this data) at www.irrationalexuberance.com/ie_data.xls, the answer is
yes. The 20 year periods ending in the early 1980s had average market
gains less than the average prime rate.
-Will
Andy
> Andy wrote:
>
> The bulk of my retirement portfolio is currently in stock (401K, IRA)
> with < 5% in i-bonds. When I read things like these I worry. :-)
> I (think) I have about 25 years or so before I need these funds.
>
> Would you mind sharing what kind of asset allocation you use?
My families asset allocation works for me, but our plans and
circumstances are different from most people so you may not learn
anything of value from what I do.
I am 43 and my wife is 38. If the opportunity presents itself, we would
like to go into semi-retirement (part time and/or low paying work) or
full retirement long before I am 65. Also, we save a lot of money
every year (probably on the order of 20-28K). To keep early retirement
an option we don't want our total assets to be too severely affected by
a market downturn in the 5-10 year time frame, and we save enough
annually that we don't need to average 10% returns to meet our
retirement financial goals. So, we only have about 40% of our non-real
estate assets (which includes 401s plus IRAs plus regular savings) in
the stock market. The rest is in 6 month CDs and T-bills earning
around 4% now (I would have it in longer term bonds but they just don't
pay enough premium over 6 month rates to be worth it right now; plus it
makes the money available to invest in real estate if and when the
bubble pops).
Even if the market permanently drops to one-half or one-third its
present value we will get by just fine (assuming nothing else goes
wrong), and if the market doubles or triples we will have even more
money to play with.
Andy
clemster
death, job loss, etc?
My thought is #1 get any "free" money in a company match, #max out
Roths, #3 put away as much as you can into the 401k and/or attack the
mortgage and any other debt. I'd rather pay taxes on income than sweat
a payment, not to mention the sooner the house is paid off, the sooner
you can up the retirement savings. Having lower expenses in retirement
wouldn't suck either.
That's my opinion, we welcome yours.