Getting A 401 Loan For A Home
If you’d like to use your 401 to cover your down payment or closing costs, there are two ways to do it: a 401 loan or a withdrawal. It’s important to understand the distinction between the two and the financial implications of each option.
When you take a loan from your 401, it must be repaid with interest. Granted, you’re repaying the loan back to yourself and the interest rate may be low, but it’s not free money. Something else to note about 401 loans is that not all plans permit them. If your plan does, be aware of how much you can borrow. The IRS limits 401 loans to either the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. For example, if your account balance is $50,000, the maximum amount you’d be able to borrow is $25,000, assuming you’re fully vested.
In terms of repayment, a 401 loan must be repaid within five years. Your payments must be made at least quarterly and include both principal and interest. One important caveat to note: loan payments are not treated as contributions to your plan. In fact, your employer may opt to temporarily suspend any new contributions to the plan until the loan has been repaid. That’s significant because 401 contributions lower your taxable income. If you’re not making any new contributions during your loan repayment period, that could push your tax liability higher in the interim.
What Is A 401k Plan Loan
A 401k plan loan is one of a few ways you can borrow money from your 401k early without incurring a penalty.
While 401k plan loans will vary depending on which plan your company offers, a few rules are constant:
- The maximum amount you can take from your 401k is 50% of the vested account amount.
- You may borrow no more than $50,000.
- If 50% of your vested account amount is less than $50,000, you can withdraw up to $10,000.
- You must repay the loan within five years.
Youre borrowing the money from your future self when you take a 401k loan and your future self is going to want that money back with interest.
Thats because when you take the money out, its no longer compounding and accruing interest. This means you will lose the gains on any amount you borrow. The interest rate is there to compensate for the loss in gains.
Now lets take a look at how to borrow from your 401k.
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Like I said before, borrowing from your 401k should be your last option when it comes to emergencies. And if youre in one now, the last thing you want is for someone to be lecturing you about what you should have done.
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Will Your Employer Know If You Take Out A 401 Loan
Yes, its likely your employer will know about any loan from their own sponsored plan. You may need to go through the human resources department to request the loan and youd pay it back through payroll deduction, which theyd also be aware of. Loans arent guaranteed to be approved either or your plan may not offer them at all. If youre concerned about a manager or executive finding out about the loan request, consider asking HR to keep your request confidential.
Weighing Pros And Cons
Before you determine whether to borrow from your 401 account, consider the following advantages and drawbacks to this decision.
On the plus side:
- You usually dont have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you repay is paid back into your account.
- Since youre borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.
On the negative side:
- The money you withdraw will not grow if it isnt invested.
- Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
- The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
- The interest is never deductible even if you use the money to buy or renovate your home.
CAUTION: Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If thats the case, youll probably have to repay the entire balance within 90 days of your departure. If you dont repay, youre in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if youre younger than 59½, you may owe the 10 percent early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.
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You Probably Can’t Take Out A Loan Directly From Your Old 401 But There Are Alternatives
A 401 is the most common type of retirement plan offered by private-sector employers, and many of these plans offer the ability to take out a loan against the assets in your plan. However, this can be challenging to do once you no longer work for the employer sponsoring the plan. Here’s what you need to know about post-employment 401 loans, and other options that may be available.
The short answerMost, if not all, 401 plans do not allow former employees to take out loans from their accounts, and actually require that any previously outstanding loans be paid back within a short period of time after leaving employment.
It’s easy to understand why — after all, while you’re receiving paychecks, the “lender” is guaranteed that you’ll repay your 401 loan as agreed. Once you’re no longer receiving those paychecks, you become much more of a credit risk. In fact, about 10% of borrowers default on 401 loans, primarily because of a job change.
While you’re technically borrowing the money from yourself, there are still legal reasons why you need to pay it back. Specifically, the tax benefits you get with a 401 are based on the assumption that you’ll leave the money alone until you retire. If you fail to pay back a 401 loan, it’s considered to be a distribution, and you’ll face the same taxes and penalties as if you simply withdrew money.
In short — 401 loans are generally made exclusively to current employees.
Borrow Wisely From Your 401
If you must borrow from your 401, make sure your employment is stable and make sure you pay off your loan in less than five years. Please do not get in the habit of borrowing from your 401. The more you can maximize contribution and leave it alone, the happier you will be 10, 20, 30 years from now.
I promise all of you that achieving financial freedom is worth it.
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Not All 401 Plans Will Allow You To Borrow
Not all 401 plans allow you to borrow against your retirement account. If your employer doesnt permit it, you wont have this option available to you.
Further, while the CARES Act allows employers to enable larger loans, it doesnt require them to do so. Even some 401 administrators that generally permit borrowing may not double the loan limits.
Youll need to check with your plan administrator to see if youre allowed to borrow at all and, if so, how much you can borrow.
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Will A 401 Loan Affect My Credit
Taking out a 401 loan has no direct impact on your credit scores.
- You don’t need a credit check to qualify for a 401 loan, so taking one out doesn’t trigger a hard inquiry and result in a temporary dip in credit scores.
- Payments on 401 loans are not tracked by the national credit bureaus , so they do not appear in your credit reports and cannot factor into credit score calculations. If you miss a payment or even default on the loan, your credit scores will not change.
Note, however, that the extra tax and penalty expenses that come with a 401 loan default can make it difficult to pay your credit bills, which can jeopardize your credit standing indirectly.
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The Benefits Of Borrowing From Your 401k
Avoid borrowing from your 401k as much as possible. A little later, well give you some alternatives to doing so but there can be a few upsides to getting a 401k loan.
First, if youre in an emergency and require money within a few days, a 401k loan can give you access to potentially $10,000 $50,000 .
You can take out a hardship withdrawal, which allows you to attain money from your 401k in certain cases. However, this comes with a 10% penalty and youll have to pay taxes on it. So a 401k loan can be an attractive option in financial emergencies like unexpected medical expenses.
Also a 401k loan can be a better alternative than turning to a bank or other creditor for a loan. Since youre borrowing from yourself, the interest you pay back goes to you instead of a third party.
Getting a 401k plan loan is also much simpler than attaining a loan elsewhere, since there are no credit or background checks.
And if the five-year repayment time isnt enough time for you, some 401k plans allow for an extension on the loan term if youre using it for certain purchases such as your first home.
But wait, dont I lose out on gains if my money is withdrawn and not compounded?
Thats a solid fear to have, hypothetical straw man. When your money isnt invested, youre not going to make gains on it but as we stated above, thats what the interest payments are for.
Those are the benefits of borrowing from a 401k plan now what about its drawbacks?
How To Borrow From Your 401k
If you’ve decided that borrowing from your retirement plan is right for you, here’s how to get money from a 401 loan.
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Early Withdrawals Less Attractive Than Loan
One alternative to a 401 loan is a hardship distribution as part of an early withdrawal, but that comes with all kinds of taxes and penalties. If you withdraw the funds before retirement age youll typically be hit with income taxes on any gains and may be assessed a 10 percent bonus penalty, depending on the nature of the hardship.
You can also claim a hardship distribution with an early withdrawal.
The IRS defines a hardship distribution as an immediate and heavy financial need of the employee, adding that the amount must be necessary to satisfy the financial need. This type of early withdrawal doesnt require you to pay it back, nor does it come with any penalties.
A hardship distribution through an early withdrawal covers a few different circumstances, including:
- Certain medical expenses
- Some costs for buying a principal home
- Tuition, fees and education expenses
- Costs to prevent getting evicted or foreclosed
- Funeral or burial expenses
- Emergency home repairs for uninsured casualty losses
Hardships can be relative, and yours may not qualify you for an early withdrawal.
This type of withdrawal doesnt require you to pay it back. But its a good idea to avoid an early withdrawal, if at all possible, because of the serious negative effects on your retirement funds. Here are a few ways to sidestep those hefty levies and keep your retirement on track.
What Happens If You Default On A 401 Loan
When you default on a 401 loan, it’s usually treated as an early withdrawal. Each plan can set its own rules, so you should check with your 401 company to see whether it handles the situation differently. When the remaining loan balance is reclassified as a “deemed distribution,” you will owe all the penalty and income taxes you would owe on any early 401 withdrawal.
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How To Use Your 401k To Buy A House
Buying a home is one of the biggest purchases youll make in your lifetime. If youre like many homebuyers, you may not have abundant amounts of cash lying around to make a substantial down payment. However, the larger your down payment, the lower your monthly mortgage payments will be. For this reason, you might consider borrowing from your 401k for down payment funds.
Alternatives To 401 Loans
Before you hit “send” on that 401 loan deal, consider these “fast cash” alternatives:
- Check your savings options. You could turn to a money market account or even a savings account that’s not earning much interest. Taking cash from either savings vehicle is less risk for your long-term financial health. You might also check into an unsecured debt consolidation loan. Such loans tend to carry higher interest rates than a mortgage refinance or home equity loan, and the interest won’t be tax deductible, but you’ll get your money, as long as your credit is decent.
- Get a low-interest credit card. There is no shortage of credit card providers with great deals on offers, particularly if your previous credit history is solid. Often, you can find APRs of 5% or even less, or even zero percent if you pay off any card debt quickly. That may be preferable to the cash you’d lose by withdrawing your 401 funds.
- Borrow from family. You’ll likely blanch at doing so, but if mom or dad can bail you out of a serious financial jam without tapping into your 401, that’s a big win for you. Just make sure all parties agree on the loan and a reasonable payback period, and keep it all in the family.
A Last Resort?
In a big picture sense, borrowing from a 401 should be an option of last resort, unless you really need the money.
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Can You Borrow From Your 401
Plan offerings: Before you count on a loan, verify that you actually can borrow from your 401 under your plans rules. Not every plan allows loans its just an option that some employers offer and theres no requirement that says 401 plans need to have loans. Some companies prefer not to. Employers might want to discourage employees from raiding their retirement savings, or they may have other reasons. For example, they dont feel like processing loan requests and repayments. How do you find out if you can borrow from your 401 plan? Ask your employer, or read through your plans Summary Plan Description . If loans are not allowed, there might be other ways to get money out.
Former employees: 401 loans are generally only allowed while youre still employed. If you no longer work for the company, youd have to take a distribution from the plan instead. Former employees dont have any way to repay the loan: You cant make payments through payroll deduction because youre not on the payroll any more.
What Not To Do
In the worst of scenarios, you’ll borrow from your retirement plan, fail to repay it and end up with your finances in even worse shape.
Don’t borrow if you’re planning on leaving. Whether you quit your job or you’re fired, you may need to repay the whole balance of your loan within 60 days or else the amount borrowed is considered a taxable distribution.
Don’t ignore your debt-to-income ratio. Treat your plan loan the way you would any other extension of credit. The classic rule of thumb is that no more than 36 percent of your gross monthly income should go toward servicing debt.
This is known as the debt-to-income ratio.
Don’t blow off your plan’s rules for loans. A 2016 study from Aon Hewitt revealed that six in 10 employers have said they’d take steps to curtail the leakage of assets from retirement plans. Those actions include limiting the number of loans available or the amount of money that’s eligible for borrowing.
Plans can also establish their own repayment and schedules, which you’ll need to follow.
“When you take a 401 loan, it comes out of payroll and reduces your take home pay,” said Cox. “Either you follow the payment schedule or you fully remit the balance due.”
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