Take a 401k loan for better investment options?

Question

I recently got into an investment discussion with a coworker about what the best way forward would be if a "trade war" does break out between the US and China. He is older and has a considerable amount of money locked up in his 401k that he is worried about. He doesn't like the funds that are offered him through our employer 401k plan and was really wanting to find some kind of commodities fund like precious metals. He is not optimistic about bond funds because of rising interest rates devaluing the existing bonds that these funds hold. We have a "Stable Market Value" fund but are unsure if that is a good option.

I got to thinking about it and proposed if it might be a good idea to take a 401k loan that he could then invest in precious metals outside of his retirement account. The interest he would pay on this loan is a payment to himself that likely would result in a higher return than what any of the available funds would do in a bear market. He seemed unconvinced that it was a good idea because if he switches jobs then he would have to pay back the loan in full immediately but I pointed out to him that any investment fund is relatively liquid so he could cash out quickly if he needed to pay it back at a moments notice.

I am having trouble seeing issues with this approach. Is this type of behavior explicitly disallowed with 401k retirement account loans? Why would this be a bad idea?

Answer 1

The investment fund may be liquid, but if markets are unstable and he loses money, he may not have enough to repay the 401k loan in case of job loss. If he's over 59.5 years old then the 10% early withdrawal penalty doesn't apply, so less risk in that situation.

A 401k loan is amortized over 5 years max, if they have over $100k in their 401k, that means the max they can take in a 401k loan is $50k (typically lesser of 50% or $50k). They have to pay back that $50k, let's say at 5% interest over 5 years. That means monthly payments of $943.56. The interest portion of those repayments is double-taxed (paid with post-tax dollars, taxed on withdrawal in the future), assuming he's in the 22% tax bracket that's a cost of $1,455, that means his returns from other investments must beat the average 401k return rate by at least 0.575% to break even. He also has to have $943.56/month extra to repay the loan each month.

Could it work out? Sure, but most people who bet on their ability to beat the market don't fare so well. It likely makes more sense to diversify with that extra $943/month rather than repay a 401k loan.