The 401k: It might be your biggest retirement investment. And there it sits, a nice fat pile of money. The 401 (k) can be a huge temptation. Meanwhile, let’s pretend you are searching for a way to source your large down payment on a perfect house. Perhaps your retirement plan–that healthy 401k—could solve your problem. Slowly you realize that, yes it is possible to withdraw or borrow from your 401k.
The Temptation Lurking in Your 401k
In fact, this trendy little idea is quite well known. However, just because you could borrow from that 401k does that mean you should? Recently we found a Mortgage Reports article by Gina Pogol that posed exactly that question. She wrote, “Just because you can borrow from your 401k to purchase a home doesn’t mean you should.” And the question is fraught with issues.
First Issue: Necessity
There might be other options available to you. You might be able to leave that 401(k) account unscathed. We advise you to investigate all your options before touching your retirement plans.
Pogol puts it this way. “…There are many low- and no-down-payment mortgage options available. You don’t actually need a large down payment to purchase a home.”
Downside A: You might borrow against your 401(k) and then, due to unforeseen events, depart from the company. Did you know you will only have 2 months to repay the entire balance?
Downside B: If you borrow against your 401(k), you’re typically not allowed to make full contributions “to your existing retirement plan.”
Downside C: Becoming such a borrower will definitely
deprive you of those nice employer matching payments to your 401k fund.
Second Issue: Legalities
First, you might not remember that the “Internal Revenue Services limits 401 k loans. These loans are limited to 50 percent of your vested account balance or $50,000, whichever is less.
Thus, if your account balance is $50,000, the maximum amount you’d be able to borrow is $25,000. And that assumes you’re fully vested.
Secondly, you only get 5 years to repay 401k loan. It must be repaid within five years. Plus, remember your payments must be made at least quarterly. And the payments must include both principal and interest.
Why Would Anyone Touch their 401k?
Here at Palm State Mortgage Company, there is a number one reason clients suggest borrowing from their 401k. They want the money for a down payment. Rest assured, we also know clients who have saved money for the down payment in spite of
the escalating costs of homes. Likewise, we find clients who have saved some money, but then discovered that closing costs swelled the price of their perfect choice of a home.
Pogal adds, “When you borrow from a 401k, you can get the money you want for a home in as little as a week and with nothing more than a phone call.
Plus, as you “pay yourself back”, you earn interest on your loan which can make the 401k withdrawal seem like a good deal.”
Then she explains a few details about borrowing your home-buying money from your 401k :
1. It is true that there’s no rule to prevent you from withdrawing your money before you actually retire.
2. For example, you might need to claim a withdrawal if you have a life emergency.
3. Likewise, it would be reasonable to borrow from your 401 k in the case of court-ordered payments.
But, we must realize these are extreme cases, termed “hardship withdrawals.” You also need to understand they come with a penalty—10 percent tax.
Risky Business: Using 401k Money to Purchase a Home
A down payment on a home is not a hardship withdrawal. However, there is a provision by which you can borrow funds from your 401(k) account. Naturally, you must promise to repay it. “Arranging for a 401k loan can be quick. With just a phone call and some written notes to your plan’s administrator, money to purchase a home be wired to you in as little as a week.”
By the way, before you pat yourself on the back for this, please realize you have just bloated the price of your loan.
Think twice: you could forgo up to 5 years of retirement fund contributions. Ask yourself what difference that would make later in your life. Now, return to the beginning of this article and read A, B, and C, above. You could consider it our Palm State Primer against taking this risk with your retirement fund.
Your 401(k) In the Balance: Points to Ponder
According to our experts at the Balance, there are some vital points to consider. Check these before you make a
withdrawal or take out a loan from that tempting 401(k) fund.
They also warn you, “If you’re unable to make that repayment, the remaining balance is considered a taxable withdrawal and is, therefore, subject to a 10% tax.”
Another Option: Cashing Out an Old 401k
If you’re under age 59 1/2 and you decide to cash out an old 401k, you’ll owe both a 10 percent early withdrawal penalty on the amount withdrawn, along with ordinary income tax. In short, money will be lost. To Palm State, this is a small tragedy.
Here’s how it looks in sample figures: “Twenty percent of the amount distributed is automatically withheld for federal taxes. This means that if you withdraw $40,000, $8,000 would be set aside for taxes.” Palm State just hates to see money murdered that way.
Here’s where the issue becomes complex. “With a 401k loan, the early withdrawal penalty and income tax would not apply, unless you leave your job. If you leave the job the remaining loan balance becomes payable in full. That’s risky business because if you don’t pay, the penalty is large: the entire amount transforms into a taxable distribution. Thus, you’d pay income taxes and the penalty if you’re under age 59 ½, and we see money murdered once again.
Does a 401k Loan or Withdrawal Make More Sense?
Looking at the potential tax bite associated with an early withdrawal, a 401 k loan could be the more tempting option. This is especially true if the option means you’d pay less what you’d owe in taxes. Of cour
se, you must not ignore the one eye-ball-scorching truth behind either option: You are shrinking your retirement savings.
Risky Business: Beating the Market
In a nutshell, “When you borrow from a 401k to purchase a home, then, one of the few ways to “beat the market” is to keep your job through the period of the loan. And also, hope that the stock market loses massive value throughout the 5-year term of your loan.” With a heavy heart, we can only say that “Borrowing from a 401k loan is a legitimate long-term risk.”
Finding an Alternative to Borrowing from Your 401k
Often you can find an option to borrowing from the 401 k by reducing the size of your down payment. That premise is false.
In today’s mortgage market environment, there are many low- and no-downpayment mortgage options available. Talk to your financial advisor and your loan broker (Palm State Mortgage Company). They can help you decide which low down payment program might make it easier to buy that perfect home.
A Menu of 7 Delicious Low Down-Payment Programs
The U.S. government backs almost all Loans. This means that they’re not going away soon.
- The VA loan (Department of Veterans Affairs) allows 100% financing2. The FHA loan (Federal Housing Administration) allows a 3.5% down payment.
- The FHFA, which runs Fannie Mae and Freddie Mac, requires just 3% down.
- The HomeReady™ program (Fannie Mae) requires just 3% downpayment.
- The Conventional 97 loan (Fannie Mae) allows 3% down.
- The USDA loan (U.S. Department of Agriculture) requires 0% down
- The Good Neighbor Next Door program (HUD) allows for $100 down.
Perhaps you should take a look at these options before leveraging your future. Try to avoid the risky business of removing money from your 401 K.
It might not feel like it now, but someday, Palm State Mortgage believes you will grow older. And you’ll be glad you did not give into temptation to murder your money-or use-any of that golden 401(k) nest-egg.