Asset Allocation Where There Are Discounted Assets

By Jo Ann M. Pinto

Conventional wisdom holds that investors should never tap into their retirement funds until they actually retire. Nevertheless, a confluence of recent events—stubbornly low interest rates, volatile equity markets, and mortgage interest rates that haven’t fallen with rates on savings vehicles—suggest that this long-held belief needs to be reexamined.

2000, 2001, and 2002 were not good years for investors. During 2000, the Dow Jones Industrial Average lost 5.02% of its value, the Standard & Poor 500 Index fell 9.10%, and the Nasdaq plunged 39.17%. 2001 was not much better; these indices fell 5.39%, 11.89%, and 20.82%, respectively, for the year. In 2002, the DJIA closed down 16.8% for the year, while the S&P500 lost 23.4% and the Nasdaq lost 31.5%. Savers taking refuge in more conservative investments have also faced paltry returns, as interest rates have fallen on CDs and Treasury Bills. To make matters worse, the cost of servicing mortgage debt has not declined as rapidly as one would expect given other economic indicators.

Ironically, now may be the time to put retirement assets to alternative uses. Specifically, now may be the time to borrow against retirement assets. Emphasis on the word “borrow”; the tax bite, which can be as high as 50% when considering federal, state, and local income taxes and penalties associated with early withdrawals from IRAs and 401(k)s, means that withdrawals should still be near the bottom of the list of options for securing funds, right above paying a visit to a loan shark.

Case Study

Consider the case of Mr. Green, which illustrates the potential benefits of borrowing against a 401(k) account. (It should be noted that borrowing against IRA assets is not permitted under current tax law.) Green, a professional in his mid-forties, is in the process of acquiring a vacation condominium. The purchase price of the condo is $90,000; Green is sinking $27,000 of his personal savings into the unit, along with a $15,000 gift he received from his parents. Therefore, he needs financing to cover the remaining $48,000. Green considered two financing alternatives: a conventional, 30-year fixed rate mortgage and, at the suggestion of the author, a loan from his 401(k) balance. At first Green was reluctant to consider the second case; an employee benefits counselor in his human resources department warned him that he would not be able to deduct the interest on his income tax return.

A 30-year fixed rate mortgage, with no points, was carrying an interest rate of 5.75% during February 2003. Green would also incur closing costs (including an application fee, an underwriting fee, and a tax service fee) of approximately $1,800 with the mortgage loan. As his HR representative correctly pointed out, his mortgage interest payments would be tax deductible.

Green’s 401(k) plan allowed for two types of loans: a primary residence mortgage loan and a general-purpose loan. Both loans were limited to 50% of his vested balance. Because he was not obtaining financing for his principal residence, Green had to apply for a general-purpose loan. The plan required that the loan be repaid within 54 months; it carried an interest rate of 6.25%. Interest payments are not tax deductible, but they are credited directly to his 401(k) balance. In essence, Green would be paying interest to himself. Finally, the loan acquisition costs were trivial: a $25 application fee.

Green and his wife had approximately $180,000 in various retirement savings accounts. These funds were invested in a diversified portfolio of equity, bond, and fixed income funds. Green, a self-described risk-averse investor, moved about half his portfolio into a fixed-income fund during August 2001. While the return was only 4.8%, Green thought it was superior to absorbing double-digit losses.

Because choosing the right alternative is a complex decision, involving interest rates, tax deductions, cash flow issues, and the opportunity cost of utilizing retirement funds, the author conducted several what-if analyses, discussed below.

Putting It Together Using Current Interest Rates

Exhibit 1 is a comparative analysis of the total projected effect on Green’s net worth at the end of the 54-month period. Calculations were done on an Excel spreadsheet; the interested reader may contact the author for the supporting details.

The net worth calculation is based upon the following set of assumptions. If Green finances through his company-sponsored 401(k) plan, his monthly payments would equal $1,016. The $48,000 loan balance would be completely paid off in 54 months. The interest rate of 6.25% is fixed over the life of the loan. Monthly installment payments are automatically deducted from his paycheck. The “equity in condo” is a conservative estimate that does not take into account the potential appreciation in the fair market value of the property.

Furthermore, it is assumed the monthly payments of $1,016 would be reinvested back into Green’s fixed income fund, which was paying 4.8%. At the end of 54 months, the portion of his 401(k) fund that served as the loan proceeds would have a value of $61,374: $1,016 x 54, plus the interest that accrues as the balance of the loan is paid off.

If Green obtains conventional financing, his monthly mortgage payment would equal $280 at prevailing interest rates. During the first 54 months of the loan, he would pay $12,046 in mortgage interest; these payments would create a tax savings of $3,132 when using a 26% blended tax rate. He will have also paid down $3,081 of the loan balance.

In order to retain consistency, the analysis further assumes that Green would invest, not spend, the monthly difference of $736 that exists between the two financing options. This money is invested in either a money market account or a short-term CD yielding 1.21% per year. Green must pay federal and state taxes of 31% per year on the interest income generated from this account. Finally, the money Green leaves in his 401(k) fund continues to earn a compounded annual return of 4.8%.

Although Green was hesitant to channel $1,016 of his current cash flow into the condo, he liked the idea that he would own it in only 54 months. Furthermore, Green believed that whatever current sacrifices he had to make, they would be offset by having a debt-free vacation home in so short a time period.

Sensitivity analysis. The analysis presented in Exhibit 1 rests on a key simplifying assumption: that interest rates on savings remain at their current levels until the end of 2007. While no one can predict interest rates with certainty, they are probably unlikely to remain at these low levels for another four or five years. In order to incorporate the likelihood that interest rates will rise, I repeated the analysis with a rate of 6.6% to the fixed fund balance in the 401(k) account and 4% to the money market account balance. These results appear in Exhibit 2. Recall that the interest rates charged on the 401(k) loan balance and the 30-year mortgage are both fixed.

Although incorporating this rate narrows the advantage of borrowing from his 401(k) account, it still makes sense to do so. It must also be pointed out that these higher interest rates were applied for the entire 54-month time period. Exhibit 2 illustrates that even if rates spike up in a year or two, the 401(k) option still prevails. In fact, short-term interest rates would have to average around 6% per year for the entire 54-month time period before the benefits would be reversed.

Other Considerations

An analysis of the above case raises several issues likely to apply to a wide range of investors. First, borrowing against a 401(k) involves almost no transaction costs. Second, the loan requests are not denied if the employee has sufficient vested funds—an important consideration for individuals that may not qualify for conventional financing. Third, interest rates on these loans are likely to be lower than on comparable unsecured loans. Fourth, the relatively short term of the loan means that a high percentage of payments goes toward directly paying down principle. Fifth, the introduction of lower income tax rates and the impending increase in the standard deduction for joint filers lessen the tax benefit of the mortgage interest deduction. Finally, in a period of dwindling investment returns, serving as your own banker may be the best use of your retirement funds.

There are, however, several important caveats for anyone considering this type of “self-financing.” First, a bull market would seriously alter the opportunity cost of tying up 401(k) assets. Second, if an employee is terminated or voluntarily resigns, he must repay the entire remaining loan balance within 90 days. If he is unable to do so, the remaining loan balance is treated as an early withdrawal, which will be taxed as ordinary income and subject to a 10% penalty. Third, because of the 90-day rule, it’s always a good idea to consider what type of back-up financing—a home equity loan, a conventional mortgage, or a line of credit—could be obtained quickly should the need arise.

Individual investors should evaluate their own financial situation in order to determine which option is best. Such a decision must take into account individual attitudes regarding investment risk and debt comfort levels. Potential borrowers must also consider how secure their employment will be over the term of the loan. Furthermore, loan proceeds should be used to fund a significant purchase, such as a second home or college tuition. As always, investors should not put all their eggs in one basket: retirement funds not included in the loan balance should be invested in a diversified portfolio.

Jo Ann M. Pinto, PhD, CPA, is an assistant professor of accounting at Montclair State University, Upper Montclair, N.J.