A 401(k) is a savings plan that is meant for an employee’s retirement. With this benefit, the employee can be certain that they have their retirement savings sorted and that they can tap into this income when they reach the age where they are deemed unsuitable to work.
However, there are others who might need to loan out a certain portion of their 401(k) to buy a house. It is possible for an individual to borrow from their 401(k) plan, but it is not advisable and should serve as a last resort. Read on to find out why it is highly discouraged to make any borrowing from 401(k) plans.
Borrowing from 401(k) for Real Estate Investment
Things to Note when Borrowing from 401(k) to buy a House
Taking out a borrowing from 401(k) account is not hard, since all you need to do is grab a hold of your plan administrator and fill out certain forms, but the tricky part in this process is how you are going to repay this loan. Here are certain things that you might need to remember when making a borrowing from 401(k) accounts:
1. If you have an old employer, you should roll over the amount you wish to withdraw from your old 401(k) with your previous employer to your IRA (Individual Retirement Account) so that you can do away with paying the penalty.
2. Plot out how you will make the monthly payment on the borrowings from your 401(k) account, along with the interest rate on this loan which goes back directly to your 401(k) fund. The interest rate on your borrowings from 401(k) accounts is usually 2 points higher than the prime rate.
3. the borrower should know the terms of repayment, such as how they will pay and the number of years that they can pay out your borrowings from the 401(k). A loan from 401(k) accounts are usually paid within 5 years, but borrowings from 401(k) accounts that are used to buy a house can be repaid within 15years depending on the terms set by the employer and employee.
4. The borrower should be aware of the possibility of incurring double taxation and penalties. The penalty for non-payment of borrowings from 401(k) is at 10%. Moreover, if the employee opts to pay their loan through salary deduction, the payment on the loan principal will not be taxed, but the payment on the interest is subject to tax. This means that the interest payment is taxed upon payment of the loan and upon eventual retirement withdrawal.
How much can you Borrow from 401(k) to buy a House
Generally, you can borrow up to half the value of your current balance or $50, 000 from your 401(k) to buy a house. The maximum amount that you can loan is the lower amount between the two.
For example, if you have $90, 000 as your current balance and you divide it by two; you would have $45, 000. This means that you can borrow up to $45, 000 from your 401(k) plan, since it is the lesser amount. However, if you have $110, 000 as your current balance and you divide it by two; you would have $55, 000. This means that you can borrow up to $50, 000 from your 401(k) plan, since $55, 000 would exceed the maximum loan amount which is $50, 000.
Advantages and Disadvantages of Borrowing from 401(k) for Real Estate Investments
Advantages of Borrowing from 401(k) for Real Estate Investments
When you borrow from your 401(k) plan, it means that you will end up paying yourself since you are technically borrowing from your retirement plan. There are other strong points included with taking a loan from a 401(k) plan.
1. Easy to Borrow from 401(k)
Compared to other loans, borrowing from your 401(k) is easier since you would only need to make a call to the administrator of your funds and fill up a couple of forms. However, if you decide to roll over from your IRA, it might be a long process and you would need to fill out more paper works. Moreover, this is not technically a debt and you would not need to factor in the debt-to-income ratio.
2. Loan from 401(k) has No Effect on Credit Score
Since your 401(k) plan is part of your assets, it won’t be reflected on your credit score. Moreover, the job scope of your plan administrator does not include reporting your 401(k) plan activities to the credit bureau, so it would not be reflected on your credit report.
3. Flexibility of Terms
The common repayment term for a 401(k) loan is five years, but you can discuss the terms with your employers and they could usually extend the repayment period for up to 15 years if you are using your 401(k) to buy a house that will serve as your primary residence.
Disadvantages of Borrowing from 401(k) for Real Estate Investments
Home buyers are discouraged from using their 401(k) account to invest in real estate. There are other downsides in using your 401(k) plan to buy a house.
1. Tax Effect when you Borrow from 401(k)
The tax from the loan on your 401(k) plan will be taxed multiple times and Ellen Chang has enumerated the tax effect of your borrowing from the 401(k) plan, “The money you borrowed is being taxed twice since you pay taxes on your salary and are using your pay check to repay the loan. Once you retire, you are faced with paying taxes again on the money being withdrawn.” (https://www.mainstreet.com/article/dipping-into-your-401k-to-finance-the-purchase-of-a-home-is-a-tricky-decision)
2. Early Withdrawal from the 401(k)
Should you leave your job or get fired from your job, it is treated as an early withdrawal from the 401(k) account. This gives you sixty to ninety days to repay the mortgage loan and you will incur an additional ten percent penalty tax. Moreover, you would need to pay the income tax related to your loan from the 401(k) account.
If you are unable to pay the loan, you are also considered to be making a taxable withdrawal that is subject to ten percent tax.
3. Halts Growth of Money
When you have an outstanding 401(k) loan, you cannot make a full contribution to your existing retirement plan which means that are letting go of up to 15 years worth of retirement fund contributions. If you add up the total amount of employer’s contribution that you are letting go for the next fifteen year, this sums to a rather sizable amount.
Unless you are certain about having a permanent source of income for the rest of your loan payment period and you are guaranteed of the longevity of your stay with your current company, it is best to stay away from borrowing from your 401(k) plan since it can possibly subject you to larger penalty payments and several taxation on one transaction. If you have several other loan options, do not resort to using your 401(k) plan and just allow the money for your retirement to grow steadily on your 401(k) account.