Should You Withdraw Funds from Your 401k to Buy a House?
Access to Funds
One circumstance in which a 401(k) loan might benefit you, according to Joseph A. Cannova, a Certified Financial Planner and Certified Public Accountant practicing in Toms River, New Jersey, is if you have bad credit. With a 401(k) loan, there's no credit check because you're borrowing your own money: there's no lender to deem you a bad loan risk or to charge you a higher interest rate. However, Cannova cautions that a 401(k) loan can't solve your entire problem because of the loan limits. You're limited to borrowing no more than $50,000 or 50 percent of your vested account balance. So, even if you have several hundred thousand in your 401(k), your loan is limited to just $50,000, which won't buy you much of a house. But, if you're just trying to limit the size of your mortgage, a 401(k) loan could save you some money by decreasing the amount you have to borrow from a bank.
Negative 401(k) Loan Tax Implications
Taking out a mortgage is much better for your taxes than taking out a loan from your 401(k) plan. You can deduct the interest you pay on the mortgage, assuming you itemize your deductions. However, if you borrow from a 401(k) plan, the interest isn't deductible. In addition, Cannova notes, "If you borrow from a 401(k), you’re paying it back with after-tax money." For example, if you fall in the 15 percent tax bracket, a $1,000 contribution to your 401(k) plan saves you $150 on your taxes. When you repay $1,000 on a loan, you don't get any tax break at all.
401(k) Loan Repayment
Usually 401(k) loans are limited to just five years, but if you're buying a primary residence, you can extend the loan for a longer period of time. However, that can all be cut short if you lose your job. “What happens if you get laid off? You have to pay the money back instantly," says Cannova. "It’s bad enough to get laid off with a mortgage.” If you cannot pay the money back when it comes due, you're considered to have taken a permanent early distribution of the funds. This means you must pay income taxes on the amount, and if you're under age 59 1/2, you're hit with a 10 percent additional tax penalty. Plus, Cannova warns that it's easy to fall in the mental trap of counting your 401(k) loan repayments as contributions to your 401(k) plan and reducing your regular contributions. If you have a separate mortgage with a bank, you're less likely to skimp on your 401(k) contributions because you won't treat your mortgage payments as contributions to your 401(k).
Missing 401(k) Investment Returns
When you have an outstanding 401(k) loan, that money is not being invested or generating additional returns for your nest egg. Cannova notes that it's not as big a deal if you happen to be borrowing when the market is doing poorly. However, if the market is returning 8 to 10 percent and you're only paying 4 or 5 percent on your loan, that's a substantial difference that could limit your retirement savings. For example, if you had $25,000 earning five percent over just one year, you'd make $1,250 less than if your rate was 10 percent.