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Large Life Purchases: Is Using a 401k Loan a Good Idea?

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May 4, 2018
Large Life Purchases: Is Using a 401k Loan a Good Idea?
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Are you thinking of making a big purchase, like buying your first house, but uncertain how to fund a down payment?

If you haven’t been able to save enough to swing the costs for a big purchase—something that might require tens of thousands of dollars—what are your loan options?

If you have a 401k with a sizable balance, you could consider taking out a 401k loan. But before you do that, be sure to weigh the potential benefits and costs of tapping your retirement account.

Everyone’s situation is different, but here are some general tips to help you if you want to start thinking about taking a 401k or a 403b loan.

Know the Terms

Josh Alpert, owner and president of Alpert Retirement Advising in Southfield, Michigan, says there are two reasons why most people take a 401k loan: to fund a big life purchase, or because they’ve had some sort of hardship and need access to cash. He says in general, a loan can be up to 50% of the vested balance, as much as $50,000.

There are pros and cons to taking out a 401k loan for a major life purchase. Alpert says two of the biggest pros are that the money is easy to access and there’s no credit check needed. “You don't have to go through a bank, and it’s a quick process. Once you've drawn out the money, you have about a five-year period to pay it back,” he says. And if you borrow to purchase a home, that five-year period can be stretched, he says.

Borrowing from Yourself = Paying Yourself the Interest

Loan rates can be low. According to 401khelpcenter.com, many loans are calculated by using the prime rate, plus 1%. Because it’s a loan, as long as you keep current on the payments, it’s not subject to the 10% penalty for early withdrawals (see Avoid Missed Payments below). And, unlike when you borrow money from a bank, you’re paying the interest to yourself, which might make those interest payments a bit more palatable.

But you can’t just smash your 401k piggy bank, take the money, and think you’re done. There are 401k loan rules that must be followed to avoid hefty penalties. And there are downsides to taking a 401k loan.

Watch those Fees, and Avoid Missed Payments

Although you have five years to pay back the loan, repayments start right away after you take out the money, according to 401khelpcenter.com. (The money is usually deducted from your paycheck.) There may also be fees involved in taking the loan. 

Alpert says if you miss a loan payment after 90 days, it’s a default, and the full value of the loan becomes taxable. If you're younger than 59 1/2, you are also subject to a 10% Internal Revenue Service tax penalty.

For loans taken before 2018, if you lose or quit your job during the payback period, then the entire amount has to be repaid in 60 days. If it’s not, then the loan goes into default, the amount becomes taxable, and the penalties for those under 59 1/2 apply. For new loans taken after Jan. 1, 2018, workers have a little more time to payback an outstanding loan once they stop working. When you leave a job, you have until October of the following year (the due date of your tax return on extension) to put the money back into your 401k.

And remember, if you withdraw funds from a 401k, it also means that money can't grow for your retirement (aside from the interest you’ll be paying yourself), Alpert says. Your account balance is actually liquidated to pay you your loan.  

There are alternatives to cashing out a 401k. You could take out an IRA or Roth IRA withdrawal, and there’s no need to repay it. But unlike the 401k loan, the money will be taxable immediately. Plus, if you’re under age 59 1/2, you’ll incur a 10% penalty for early withdrawal.

The upshot? A loan from your 401k can be a viable option if you’re looking for cash to help fund a big purchase. But if you think you might be leaving your current job soon, or you’re not willing to swap out your current 401k investments for an interest rate investment with yourself as the issuer, you might want to think twice before proceeding. 

Remember you can borrow from a bank for a house or even a child's education expenses, but you can't borrow from the bank to fund your retirement.

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