Investment

Major Purchases Over Life: Is Using A 401 (k) Loan A Good …


If you are considering borrowing against your 401k to finance a large purchase like a home, carefully consider the rules, pros, and cons of the 401k loan.



5 minutes to read

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Key points to remember

  • Weigh all your options, including taking out a bank loan or IRA withdrawal
  • Learn about your employer’s 401 (k) plan loan provisions
  • Continue to contribute to your 401 (k) plan while you pay off the loan
  • Know the terms of your loan, including repayment rules and potential penalties

Thinking about making a big purchase, like buying your first home, but don’t know how to finance a down payment?

If you haven’t been able to save enough to reverse the costs of a large purchase, which can cost tens of thousands of dollars, what are your loan options?

If you have a 401 (k) with a large balance, you may want to consider taking out a 401 (k) loan. But before you do that, be sure to weigh the potential benefits and costs of using 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 out a 401 (k) or 403 (b) loan.

Know the conditions

Josh Alpert, owner and president of Alpert Retirement Advising in Southfield, Michigan, explains that there are two reasons most people take out a 401 (k) loan: to finance a big life purchase, or because they have had difficulties and need access to cash. He says that in general a loan can represent up to 50% of the acquired balance, up to $ 50,000.

There are pros and cons to taking out a 401 (k) loan for a large life insurance purchase. Alpert says two of the biggest advantages are that money is easy to access and no credit checks are needed. “You don’t have to go through a bank, and it’s a quick process. Once you take the money out, you have about five years to pay it off, ”he says. And if you borrow to buy a house, that five-year period can be extended, he says.

Borrowing from yourself = paying the interest

Loan rates can be low. According to 401khelpcenter.com, many loans are calculated using the prime rate plus 1%. Because this is a loan, as long as you stay up to date on payments, it is not subject to the 10% penalty for early withdrawals. Avoid missed payments below). And, unlike what you borrow from a bank, you pay interest at yourself, which could make these interest payments a little more acceptable.

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


Watch for these fees and avoid missed payments

Although you have five years to repay the loan, repayments begin immediately after the money is withdrawn, according to 401khelpcenter.com. (The money is usually deducted from your paycheck.) There may also be fees associated with obtaining 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 are under 59 1/2, you are also subject to a 10% Internal Revenue Service penalty tax.

For loans taken out before 2018, if you lose or quit your job during the repayment period, the full amount must be repaid within 60 days. If not, the loan is in default, the amount becomes taxable and penalties for less than 59 1/2 apply. For new loans taken out after January 1, 2018, workers have a little more time to repay an outstanding loan after they stop working. When you leave a job, you have until October of the following year (your tax return due date if extended) to put the money back into your 401 (k).

And remember, if you take funds out of a 401 (k), that also means the money can’t grow for your retirement (other than the interest you’ll pay yourself), says Alpert. Your account balance is effectively liquidated to repay your loan.

The result ? A loan for your 401 (k) may be a viable option if you are looking for the cash to help fund a big purchase. But if you think you might be quitting your current job soon, or if you’re not prepared to sacrifice the potential growth of your retirement savings, you might want to think twice before continuing.

Remember, you can borrow from a bank for a house or even for a child’s education costs, but you cannot borrow from the bank to finance your retirement. Before making a final decision, consider working with a tax planning or finance specialist to understand the potential impact a 401 (k) loan could have on your retirement savings and tax bill.



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