Should You Borrow from Your 401K?

Should You Borrow from Your 401K?

This question starts 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. 

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 completely and you never plan on paying it back. Generally, don’t do this. Unless you have a personal emergency and your hand is forced. To give you an example, if you pulled out $10,000 as a distribution, you could pay up to $3,000 in taxes and penalties. Very expensive!

The other way is to take a loan. In this scenario, you’re basically borrowing your own money from your 401(k) and promising to pay yourself back with some interest over time.

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 thinking of using it, I would generally ask you things like, 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 other options, we should take a look at your 401(k).

When making this decision, there are three important things to consider. 

Market conditions are extremely important. If you were considering borrowing from your 401(k) in 2017-18, that was a great time to pull your money out of the market and reallocate it toward something else. But in 2009, that was not a great time, because the market was at a decade low! 

If you pull money out at a low point, you totally 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 when you pull that money out and you place it into a house, your money is still working for you.

Another thing to consider is the payback period. We do want to get that money back into your 401(k) sooner than later so you can start taking advantage of compounding market returns. Personally, I don’t want to see you keep it out too long because it can really damage your retirement future.

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 definitely 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 rules for their 401(k) dictated that it had to be paid off within 60 days. If it couldn’t be paid off, they would pay taxes and penalties on the outstanding balance. That could be a very substantial penalty, up to 30% or more.

So, 401(k) loans are not for everybody, but they are a very useful tool that I’ve seen used quite successfully time and time again for new home buyers.

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