Knowing you’ll have to pay yourself back might give you peace of mind, but there are many risks to borrowing from a 401(k) before retirement.
Truth talk: Saving for a down payment can be hard, and it’s easy to get caught up in the excitement of house hunting. So if you’ve fallen in love with a home for sale in Charleston, SC, before your down payment is mature enough to make a move, you may be tempted to break into your 401(k). After all, it’s your money and you work hard for it — you trust yourself to pay it back, right? Not so fast. There are serious downsides to borrowing from a 401(k) that could really cost you down the line.
More truth talk: If you need to borrow against your 401(k) to afford to buy a home, it’s likely that you probably can’t afford the house to begin with. That’s the number one reason to avoid pulling from your 401(k) for your down payment. “You need to look and see where your money is really going — can you truly afford this? Is there money to be saved from your entertainment budget, for example?” asks Eric Freckman, president and CEO of Illinois-based Guillaume & Freckman Inc. and a certified financial planner. “We strongly advise that you have other funds for [a down payment], because [borrowing from a 401(k)] can add a lot of financial stress.”
But if the potential for living beyond your means doesn’t turn you off, here are four more reasons taking out a 401(k) loan might not make the most financial sense.
Even if you borrow from your 401(k) for a house, you’ll still need those savings
Unlike an IRA withdrawal, you’ll have to pay back any money you take out of your company’s 401(k) plan. That sounds pretty good, right? It’ll keep you honest in repaying yourself. Well, not exactly. If you lose or leave your job, you could be required to pay back the outstanding balance within 60 to 90 days or be forced to claim it as a hardship withdrawal (which incurs a 10% penalty and taxes the withdrawal as income). After all, if you were stretched enough financially to borrow from yourself in the first place, you likely won’t have the money down the line to cover what you owe in one big chunk. And there are many other costs associated with homeownership. “If you can’t save the money for the down payment, it will be exponentially harder to save for the other associated costs, like repairs and property taxes,” Freckman adds. Consider repairs and other expenses that may pop up after you buy before you get in over your head.
A 401(k) loan can compromise your future wealth
The typical 401(k) loan usually allows you to borrow up to 50% of your balance, up to a maximum of $50,000. Here’s a scenario: Say you want to take out the full $50,000, which was growing, conservatively, at 7% annually. According to Freckman, if you borrow from a 401(k) at age 40, in 20 years that money would have grown to a whopping $193,000. Fast-forward to you at 60, theoretically much closer to retirement, and you’ve taken a huge hit on your future finances (bye-bye, retirement beach house!). Not only that, but also the money you were using to pay yourself back all these years was the same money you should’ve been saving, making matters even worse for retirement. Most advisers will tell you that your 401(k) is sacred, only to be used for retirement. In this case, it might be better to keep renting and save for the future.
You could be penalized for and taxed on early distributions
There are some situations the IRS considers OK when it comes to borrowing from your 401(k) plan before you hit 59.5 years old, but (surprise!) a home purchase isn’t one of them. When you borrow from your 401(k), you incur a 10% additional penalty on the early distribution, because the amount is now considered taxable income. What’s more, since your contributions are made with pretax money, when you go to repay the loan, your payback will be made with after-tax dollars. Essentially, you’ll be double-taxed on that money. Whomp, whomp.
Borrowing from your 401(k) can start a pattern
Think of it this way: Once you’ve done something, it’s much easier to do it again, right? It’s human nature. Turns out, there’s no difference when it comes to taking out a loan. Fidelity, the home of millions of workers’ 401(k) funds, surveyed the behavioral patterns of repeat borrowers and found that those who borrowed from themselves were much more likely to do it again. “People who live beyond their means continue to do so over the long term,” says Freckman. “People who are financially conservative tend to stay that way also.” Instead, he suggests a thought-out, long-term plan — whether that means buying a less expensive house or reducing your retirement contributions slightly to ramp up your savings plan for a hefty down payment.