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Participant Loan Strategy for Enterprising Investors

Participant Loan Strategy for Enterprising Investors

As an employee benefits practitioner, I have long argued against participant loan features in 401(k) and other tax qualified retirement plans. When employers insist on participant loan availability, I encourage them to consider adoption only in the case of a participant’s financial hardship. The consequences of taking a 401k participant loan are numerous:

  • Once a plan disburses loan proceeds, participants are out of the market and forego potential upside investment returns
  • Participants repay loans on an after-tax basis, frequently through payroll deductions
  • Loan interest is not tax-deductible, as it is considered ordinary consumer debt
  • Generally, if participants terminate employment prior to repaying the loan, the balance becomes immediately due, or the loan is deemed a taxable distribution with a 10% penalty, if the participant is under age 59 ½.

However, a strategy exists for which a 401k loan could help investors who maximize annual 401(k) contributions to accumulate greater wealth and take advantage of a tax deduction opportunity. This strategy is intended only for experienced investors as it is complicated and involves considerable risk.

The approach necessitates originating a 401k participant loan, opening a margin investment account with the loan proceeds, and investing in a diversified equity portfolio. We will explore each of these steps in further detail.

Originating a 401k Participant Loan

Qualified plans may originate participant loans only under conditions intended to prevent abuse and safeguard plan assets. Loans must be available to participants on a reasonably equivalent basis, with consideration given only to factors such as creditworthiness and financial need. You will note these factors are also considered in normal commercial lending situations if participants were to apply for a consumer loan outside the plan. Loans must also be adequately secured and bear a reasonable interest rate. A participant’s account may collateralize the loan, but no more than 50% of the vested balance may be used to secure all plan loans to a participant. Participants may originate a loan for up to $50,000, reduced by the excess of the highest outstanding balance of plan loans during the preceding one-year period. Loans must be repaid in five years, unless participants use the proceeds to acquire a principal residence.

Given these factors, let us consider a specific example: Emily is a 401(k) plan participant and maximizes her 401k salary deferrals to the annual limit, which is currently $16,500. She has a $100,000 vested account balance and wishes to originate a $50,000 general-purpose loan, secured by 50% of her account. The Plan Administrator indicates Emily’s loan would bear interest at Prime + 2% — 5.25% based on current rates, with repayment through semi-monthly after-tax payroll deduction. The amortization schedule indicates Emily’s semi-monthly loan payment would be $474.20 and she would pay $6,904 of interest to her retirement account over the 5-year term.

Opening a Margin Investment Account

Investors can open margin accounts with brokerage institutions. Margin accounts enable investors to borrow money to purchase securities. The amount investors can borrow is typically limited to 50% of the value of marginable securities. The financial institution charges investors margin interest for the right to borrow money and uses the securities as collateral. Margin interest can be tax-deductible up to the amount of net investment income received, which can provide investors with meaningful tax benefits. Margin interest rates vary among brokerage institutions, but among the most competitive is Interactive Brokers (www.interactivebrokers.com) which, as of this writing, had rates of approximately 2.5% on margin loan balances less than $100,000.

Margin trading increases buying power, enabling investors to purchase a greater amount of securities with their investing dollars. Taking the earlier example, suppose Emily opens a margin account at a brokerage institution with her $50,000 participant loan proceeds. Although her account would only have $50,000 cash, Emily has up to $100,000 in buying power, since 50% of a marginable security’s value could collateralize a margin loan.

However, margin trading also increases exposure to market volatility, so a declining market could result in substantially greater losses. Moreover, if the equity in the margin account falls below minimum maintenance requirements, the brokerage institution will issue a margin call, which requires investors to deposit cash or other acceptable collateral in the margin account. Equity is determined by subtracting the margin debit balance owed to the brokerage institution from the market value of securities. Minimal equity requirements vary among brokerage institutions, but are typically 30% to 50%. If an investor fails to meet a margin call, the brokerage institution will sell some or all of the securities in the account to protect its margin loan, without investor prior approval. As previously mentioned, this strategy is unsuitable and inappropriate for inexperienced investors.

Investing in a Diversified Equity Portfolio

A diversified equity portfolio, capable of delivering income plus capital appreciation in excess of the investor’s margin interest rate brings the overall participant loan strategy full circle. Although the portfolio’s dividends and capital gains are taxable, margin interest paid can be deductible, up to the net investment income received.

Although diversified, equity mutual funds are less suitable for this strategy than exchanged traded funds. Exchange traded funds provide the diversification benefits of mutual funds, without taxable capital gain distributions, making them well-suited taxable brokerage account investment vehicles. Like stocks, they trade intraday with bid/ask spreads and tend to be very cost efficient.

Referring again to our earlier example, suppose Emily uses the $100,000 buying power within her margin account to purchase 1,000 shares of a broadly diversified exchange traded fund trading at $100 per share. Presuming the exchange traded fund returns 8% net annual investment returns, compounded semi-monthly, the value of Emily’s taxable brokerage investments would grow to $149,083 over 5 years. During the same period, Emily’s margin loan increases by $6,756 of margin interest.

Moreover, presume Emily experiences an identical 8% average net annual investment return, compounded semi-monthly, in her retirement plan account. After originating her participant loan, Emily’s retirement account balance was reduced to $50,000. Considering her loan repayment schedule, annual 401k elective deferral contributions, and compounded investment returns, Emily’s retirement account would grow from $50,000 to $245,602 over 5 years. Add to this her taxable brokerage account and Emily’s overall balance is $394,685.

Had Emily not adopted the participant loan strategy, continued maximizing her 401k elective deferral contributions, and experienced an 8% average net annual investment return, compounded semi-monthly, in her retirement plan account, Emily’s account balance would grow to $250,318 over 5 years.

Participant Loan Investment Strategy Outcomes

Although on the surface it appears the participant loan strategy worked remarkably well, we must make certain adjustments for an apples-to-apples comparison. First, we must adjust for Emily’s total loan repayments of $56,904, since Emily repaid the loan with her own money. Next, we must adjust for Emily’s margin debit balance of $56,756, since she must repay the margin loan to the brokerage institution. Emily’s adjusted balance under the participant loan strategy is $281,025 — $30,708 ahead of where she would have been without the strategy.

Participant loans are seldom advisable. Although this strategy is unsuitable and inadvisable for the vast majority of retirement plan participants, experienced investors willing to take additional risk can leverage this advanced strategy to earn potentially greater investment returns. As always, consult with your professional advisers before adopting any new strategies, as each individual’s tax and financial circumstances are unique.



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