How should you invest your 401k?

Last time I wrote about my dislike of mutual funds as investment vehicles. The problem is that mutual funds are usually the only investment in 401k plans. So should you just avoid investing in a 401k then?

No. The tax benefits of using a 401k are way too good to pass up. The maximum 401k contribution for 2008 is $15,500. If you saved that $15,500 in a savings account instead, and you were in the 25% tax bracket, you’d pay $3875 in taxes, leaving you with just $11,625 in savings. So by depositing that $15,500 into a 401k, thus getting to keep it all, you get an instant, risk-free gain of 33% over what you would have had. If your tax bracket is higher, your risk-free gain is even higher.

That tax gain is over and above any matching your employer gives you, which would just be icing on the cake.

So now the money is in the 401k, but I’ve still said mutual funds are bad, and since that’s the only investment option, what should you do?

An ignored investment option

Mutual funds aren’t exactly the only investment. There’s another one that most financial advisors will frown at and call a “bad idea”. But just like electricity, kitchen knives, and options investing, dangerous tools can still be used safely and profitably if you use them right.

The investment I’m referring to is 401k loans. Most 401k plans allow you to take a loan against your balance. In many cases they allow you to borrow up to 50% of your balance.

You pay interest on the loan at a rate set according to the current interest rates, and you make payments on the loan generally straight out of your paycheck.

Benefits

The foremost benefit is that you can now invest the money that you borrowed in whatever you want.

The second is that you are now paying your 401k interest, so you’re depositing more money than you would have otherwise been able to and that money can grow tax-deferred. Also, you’re usually getting a pretty good interest rate. And because you know the borrower better than anyone, there’s a good deal less risk involved in making the loan (as opposed to loaning money to a company through a bond).

The third benefit would be that if or when you leave your job, you’d be able to roll the 401k into an IRA. IRAs allow you to invest the funds pretty much any way you want (there are a few restrictions), so putting more money into a 401k now in the form of loan interest will give you more money to freely invest later.

Dangers

The one that you should be most aware of is if you leave or lose your job, you usually only have about 30 days to pay the money back to your 401k or you will owe taxes on all of the money. So that means you shouldn’t invest the money in anything where it will be tied up for a long time, or that might fall in value.

Another danger is that you might be required to pay back money faster if the value of your account drops. Remember you are only allowed to borrow 50%, so if you have $20k, and you borrow $10k, leaving the other $10k in your 401k in a mutual fund, and that mutual fund takes a nose dive dropping your account to $5k, you’ll now be borrowing 66%. But since I don’t like mutual funds anyway, that’s not really a problem. Just stick the funds that are still in the 401k into the money market fund in your account. Those funds will earn about 2-3%, which isn’t very high, but there’s no chance they’ll go down in value.

The remaining danger that comes to mind is a willpower weakness. Don’t borrow from your 401k if you are planning to spend the money or you think you might be tempted to spend it. This money is for investing only. Spending the money would be like sticking your tongue in a light socket, or juggling the kitchen knives. It’s not the safe way to use this tool.

Other

Borrowing money from your 401k only really makes sense if you are maxing out your 401k contributions and want to get more money in there to grow tax-deferred, or if you already have a large 401k balance (more than the maximum contribution), and don’t want to invest in mutual funds.

In the last article I asked the question, “If you’re going to dull both [gains and losses by diversifying], why not just avoid investing altogether and just save your way to retirement?”. I was being half serious about just saving. Sometimes just saving and not investing is a good move to make. If you don’t have enough in the 401k for it to make sense to borrow, then I would suggest just leaving all the money in the money market in the 401k. You already received a 33% gain just by making the deposit, so be happy with that and keep feeding the nest egg until it grows big enough to make borrowing make sense.

Something else to note is that the interest you pay on the 401k loan is generally paid with after tax money. This means that you might pay taxes twice on the interest you pay to your 401k. You’ll pay once when you take it out in retirement, and possibly once when you pay it in as interest.

Personally, I have taken a 401k loan and invested the money and then claimed the interest as investment interest on my taxes. I was following the spirit of the law, the interest was an investment expense, but I’m not certain that the IRS will see it the same way. So you may or may not be able claim the interest as a tax deduction. If you’re willing to gamble on paying the fines or your tax advisor says its copasetic, then give it a whirl. But just to be clear, I’m not advising you to claim it on your taxes, just pointing it out as an option.

Perfect investment for a 401k loan

Last weekend, the No Lose Stocks service started taking subscribers. That link explains the service and has the link to subscribe via PayPal.

Since a 401k loan investment needs to be something that doesn’t tie your money up for a long time and that doesn’t have a possibility of falling in value, No Lose Stocks fits the bill perfectly. The put option protects the invested money so that it can’t be worth less than the initial investment, and since the put option can be exercised at any time, it allows you to close out the position at any time and get the money back if you need to quit your job or get fired.

In case you’re interested, here’s the link to the No Lose Stocks spreadsheet for today (Friday, August 29, 2008).

Personally, I like to sort the list by “Percent To Profit” from smallest to largest. “Percent To Profit” is how much the stock has to gain to be above the strike price of the put option. After the list is sorted, I start looking down the list for stocks that are 3-6 months out in their put option expirations, and that aren’t in some kind of possible buy out situation. It seems that a stock that is about to be bought out usually has a very low “Percent To Profit” because people don’t think it will go higher than the buy out price.

If the service interests you, sign up and try it out. There’s a 6 month free-trial for all subscribers, and if you don’t like it, you can cancel from your PayPal account and don’t even have to contact me.

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