Should You Borrow from Your 401K?
This question starts in one of the following two ways. “John, I have a 401(k). What do you think about borrowing those funds to buy my house?” Or, “John, I have a 401(k), but I don’t even want to talk about borrowing from it. It’s not an option. The money is staying there.”
Before you can think about using that money to buy a home, you first need to know what type of loans exist and what implications there could be for accessing the funds.
How Can You Access Your Retirement Savings
There are two ways to take out money from your 401(k). One is a distribution, and the other is a loan.
A distribution is taking your money out entirely and never planning on paying it back. Generally, you should avoid this unless you have a personal emergency and your hand is forced. For example, if you pulled out $10,000 as a distribution, you could pay $3,500 or more in taxes and penalties. Very expensive!
The other option is to take a loan. In this scenario, you’re borrowing money from yourself and promising to pay yourself back with a bit of interest over a specified period. The loan payment is generally set up as a payroll deduction which automatically reduces your take-home pay.
So, back to the question. Should you borrow from your 401(k)? Well, the answer is, it depends. As a core principle, I’d like to see you keep your money in your 401(k) as much as possible. If you are considering using it, I would generally ask you, are there other things you can do to buy that house, such as lower down payment options? Is a family gift possible? But if there are no alternatives, we should look at your 401(k).
When making this decision, there are three essential things to consider.
Market Conditions
Market conditions are critical. If you were considering borrowing from your 401(k) in 2021, it could be a great time to pull your money out of the market and reallocate it toward something else given the S&P 500 is at an all-time high. But in 2020, during the COVID-19 market sell-off, we would have advised against it.
If you pull money out at a low point, you miss the upside swing of the market as opposed to pulling it out at a high, where the market potentially could dip. At least you know that when you pull that money out and place it into a house, your money is still working for you.
Loan Repayment Term
Another thing to consider is the payback period. We want to get that money back into your 401(k) sooner than later so you can start taking advantage of compounding market returns. Keeping money out too long can damage your retirement future. In a perfect world, you would have your 401(k)-loan paid back within 3-4 years.
Tax Consequences
The last and most important are the taxable events. If you borrow money from your 401(k) and then take a new job, that could create a taxable event. This is something you must understand! I’ve had several clients take a 401(k) loan and then find a new job. When they left their previous employer, the 401(k) rules dictated that it had to be paid off within 60 days. If it could not be paid off, they would pay taxes and penalties on the outstanding balance!
Pro-Tip: We recommend getting a Home Equity Line of Credit as soon as you have enough equity to pay off the 401(k) quickly. The compounding effects of market returns over many years will generally earn more than the cost of the HELOC interest!
401(k) loans are not for everybody, but they are a handy tool I have seen used repeatedly for new home buyers.
