Should You Borrow From Your 401k?

Financing

Should You Borrow from Your 401k?

Many people don’t know it, but as an employee with a retirement plan known as a 401(k) you are normally allowed to “borrow” from the plan assets. If the employer allows it, you are able to create a loan for up to 50% of the plan assets. The question is, should you?

What Are the Benefits? 

  • Unlike a traditional mortgage, the loan is not reported to the three credit rating companies like Transunion. That additional loan does not affect your rating.
  • In order to qualify with the IRS as a loan, you will have to pay interest on the loan. Normally, that amount is much less than a traditional mortgage.
  • While we are talking about interest paid, whatever that amount is goes back into your plan assets. The effect is that you are paying yourself the interest rather than the mortgage company.
  • Your plan assets are yours. There is no qualifying for the loan. If your employer allows loans, most do, you can assess the money usually within 7 to 10 days.
  • Again, your plan assets are yours. Normal mortgage companies want collateral, the home purchased. The loan from the retirement plan does not require any collateral.
  • Since it is a loan, there is no 10% early withdrawal penalties or income tax on the loan from the Internal Revenue Service.

The Negatives

  • You have the money in your pocket; therefore, you will not earn any interest or have a gain in plan assets. If you had left the money in the plan you might have realized an increase in plan assets.
  • Earlier we talked about paying interest. In a traditional mortgage any interest can be deducted from your income tax return to certain limits. Using the plan assets, you are not allowed to deduct any interest paid. It’s going back into the plan; the IRS is not going to allow you to keep the interest AND take a deduction. With the change in tax laws this year, not being able to deduct interest may not be an issue.
  • Some plans do not allow contributions to the 401(k) while there is a loan. This could also reduce your ultimate retirement benefit.
  • If you terminate your employment, you will have to repay the loan in full usually within 30-60 days. If you don’t, the IRS considers it a forgiveness of a debt and taxes are due on the balance. One way to repay is to get a traditional mortgage prior to termination of employment and use the proceeds to pay off the plan loan.
  • Finally, if you default on the plan loan, it is considered a withdrawal. Your friendly IRS will want not only normal income taxes on the amount, but a 10% early withdrawal excise tax could be due depending on your age at the time.

Is It A Good or Bad Thing?

Do your homework! Like a lot of things in life, it depends. They only real way to determine which way to go would be to sit with a financial advisor or income tax specialist. Let them review your ideas and give you the best advice for your situation. If you would like a couple tax professionals to contact, we can help. After 30 years on the business, we have come across professionals we trust.