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While trying to time the market is a flawed and futile exercise, timing the taxation of investments is not. In fact, as an "advisor" (not "adviser") I would argue this is mandatory.
Recently I wondered, could we use a hated, dreadful tool, like a 401(k) loan to financial benefit the consumer? Yep, I'm that cool that in my spare time my thoughts are perpetrated by fun ideas like that. As boring as it sounds, a 401(k) loan can be useful if the loan proceeds are deposited into a Roth IRA. Odd but true!
There are three main components that make a 401(k) loan/Roth IRA combination advantageous.
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First, it is the manipulation of consumer behavior. In my experience, individuals who take out a 401(k) loan do not factor the slight additional federal tax liabilities into their decision.
Second, if we take the loan after a short-term negative fluctuation in value, then we can exploit the "buy and hold" strategy, or the "the-market-will-always-back" belief, by paying the tax on the depressed amount and allowing the growth to be tax-free (similar to the required minimum distribution example). Thus, allowing for increased withdrawal capacity.
Third, tilting the Roth to be completely growth creates a definitive mathematical advantage. Interestingly, except for the increased withdrawal capacity, the first two benefits are purely behaviorally superior while mathematically equal; whereas, the third and final benefit is mathematically superior while behaviorally inferior.
Timing the taxation of investments to take advantage of short-term market fluctuations isn't as difficult as it sounds. In fact, I bet you're already doing it.
I want you to imagine one of your clients, Bob and Mary, who own small business, have just shared that their income this year will be the lowest it's been in decades. They expect their taxable income to drop from north of two-hundred large to just about fifty-grand. You all agree this is a short-term fluctuation (think industry shift, or unusually large depreciable deduction) and although it's painful to pay additional taxes right now, you show them how a partial Roth IRA conversion would take advantage of their unseasonably and temporarily lower marginal rate. Very important, although often overlooked, Roth IRA distributions do not factor into whether future social security benefits are taxable, since all the growth is 100% tax-free.
There's other examples of how we can utilize tax rules to increase net investment gains, but the 401(k) loan is one I haven't seen mentioned before. Let's get the icky part of this over.
Yes, I know a 401(k) loan typically has a reasonable interest rate, and yes, it's true the interest paid goes back into the loan recipient's 401(k), but the loan repayment is characterized as income, making the interest double taxed (only the interest since the "principal" already reduced the tax liability once and was not taxed when it came out as a loan). Most importantly though, too often I've seen a 401(k) used as a quasi-emergency fund, which it is not.
If you believe the market will always come back, then we can manipulate when taxes are paid to capitalize on negative short-term market fluctuates. Further, we can use negative consumer behaviors to increase long-term consumer successes.
To illustrate, let's look at one of your clients again. She is 72-years-young and owns XYZ investment which has recently dipped 30%. She it's a good investment and doesn't want to sell it to cover her $7,000 annual RMD. With her beliefs, she should sell it now and reinvest the RMD into an after-tax account. The $7,000 of XYZ stock today, was previously worth $10,000. Selling now, she would owe ordinary income tax on the $7,000 but would pay long-term capital gains (LTCG) on the growth, if she holds the new shares for at least one year. The long-term capital gains rate is 0% for those in the 10% and 12% federal brackets. If XYZ does recover, she will save ordinary income tax on $3,000. Despite this, this is a behavioral advantage, not a mathematical one.
Technically, if she reinvests $7,000, rather than an amount after taxes, then she's slightly increasing her total investment. If she invested the after tax, then it would be equal. For example if $100 pre-tax grows by a factor of 10, then the after-tax value is $800 ($1000 – 20%). If $80 after-tax grows by the same factor, then the value is also $800.
However, wouldn't you agree, consumer sentiment is "I'll take it now and pay for it later (taxes included)". Thus, she'll defer the tax liability to the follow year, or have it withheld and still re-invest an even $7,000. There's also something to be said that this is a Required distribution.
What about wash rules, you ask? They don't apply when going from a qualified account (IRA) to a non-qualified account, but important they do apply when going the opposite direction, non-qualified to qualified. But let's move on
Okay we've established we can manipulate simple tax rules for your clients' benefit during periods of short-term income fluctuations and possibly during short-term market fluctuations, but can this be done with a 401(k) loan?
Before we go further, it's easier for me to list my assumptions. Below are the basic assumptions I used:
- $100,000 401(k) balance
- $415 per month either for contributions or loan repayments
- $21,991 401(k) loan at 5% Interest repaid equally over 5 years
- 60/40 Allocation (U.S. Stock Market and Total U.S. Bond Market)
- Same costs etc. between 401(k) and Roth IRA
- 20% marginal federal tax rate
- 30-year time horizon
Here are some answers to common questions I can imagine readers asking? If you don't care skip down past this section.
Q: Why a 5-year loan term?
A: It's, since this is the longest allowed by the IRS. A longer term creates more interest, which is double taxed, thus this should favor the no loan examples.
