Thursday, October 18, 2012

Borrowing from your 401(k)-Good idea? Bad idea?

Your 401k is a multifaceted financial tool. Not only can it save you money on taxes as it defers income tax on the money you save for your retirement, it can also play an important role in purchasing a home or even help you get out of debt. Believe it or not, if you are a first time homebuyer, you can draw money from your 401k or Traditional IRA without penalty. That does not mean you won’t pay taxes on what you draw out, it means you won’t have to pay the 10% IRS tax penalty if you draw the funds to purchase a first home.

Not only can you draw on it for a home purchase, you can borrow against it. You can borrow up to $50,000 or half of your 401k, depending on which is less. When you borrow for a home you get a longer pay back period, up to ten years. If for any other use, you will only have five years to repay. The bimonthly payment will be evenly spread out or “amortized” over the time period and will be taken after taxes from your check. The interest you pay gets reinvested in your account. Your money remains in the account working for you. Remember, this is a loan not a withdrawal.

There are advantages and some major disadvantages for borrowing against your 401k for a home purchase:

  • Advantages: The money in your retirement account continues to work for you when you borrow against it. If you withdraw, you lose any shot at future market earnings.

  • There are no tax penalties for taking a loan out on your 401k and repaying it.

  • The interest you pay goes back into your 401k as a contribution for you and is added to your retirement funds.

  • I have never seen a 401k loan show up on a credit report. You are borrowing your own money so it does not count against your FICO score. Borrowing from most consumer sources will have an affect on your credit report and score.

  • Your monthly payment is taken automatically from your paycheck by your employer and credited against your loan by the 401k trustee.

Some Major Disadvantages

  • If you leave your employer early, they will need to pay off your loan from the proceeds of your 401k retirement plan. It does not matter if you quit, are fired or laid off. The 401k trustee will debit the loan payoff amount from your retirement account and pay off the outstanding portion of your loan. This withdrawal will be subject to taxation and Federal IRS early retirement plan withdrawal penalties. You will pay a 10% tax penalty on the amount withdrawn and also be subject to ordinary income taxes on the pay off amount. Depending on where you live, there may also be state taxes and penalties on a withdrawal such as this.

  • For some plans, when you take a loan against your 401k, you may not be able to make contributions for the time your loan is outstanding. Meaning that your retirement savings will stop until your loan is paid off. Check with your trustee for details.

  • You are also repaying part of the loan with money that has already been taxed. As you know, one of the benefits of contributing to a 401k is the fact that the money is invested pre-tax. When you take a loan you aren’t taxed on the proceeds, but the money used to repay the loan has already been taxed so your additional interest going into the account will effectively be taxed twice–at the time of contribution and again when eventually withdrawn from the account in retirement. Ouch!

Most Human Resource professionals will counsel you not to take a loan on your 401k for the very reasons I described above. Not everyone stays at the same employer for 5-10 years. In the U.S., employees tend to last 4.4 years on the job according the Department of Labor Statistics. Younger employees last shorter amounts of time and older employees may stay on longer. The bottom line is that very few Americans remain on the job for the full ten years it takes for one of these loans to mature.  

You need to consider many variables when thinking of taking money from your 401k either as a withdrawal or as a loan. Some of the questions you need to ask are: How much do I need? What is the penalty if I withdraw it? How much are my taxes on that withdrawal? What is my advantage in taking out a 401k loan? How long do I plan to remain at this workplace?    

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  1. Great article! The real question Greg is may I borrow from your 401(k)?

  2. Frank, Thank you. Since the market dropped today, you definitely don't want my 401(k)!