The Pros and Cons of Borrowing Against a 401(k) for a Down Payment on a Mortgage

If you’re in the market for a new house, you might be wondering if you can tap into your workplace 401(k) to cover the down payment. The short answer is yes, but there are definite disadvantages in doing so. Let’s take a look at some of the pros and cons to this approach.

Benefits of Borrowing from a 401(k) to Make a Down Payment on a House

  • You’re borrowing from yourself rather than another lender, which means you might not be losing as much money on interest payments as you would if you acquire the funds through other means, like taking out a larger home loan to cover your down payment costs.
  • The loan approval is typically hassle-free. Provided your workplace plan allows for loans, and you do indeed have sufficient funds in your 401(k), your credit score and other financial credentials shouldn’t impact your ability to borrow against it.
  • The process is typically quick. Every plan is different and works on its own timeframe, but once you’ve decided to borrow from your 401(k), it’s usually just a matter of filling out a few forms to gain quick access to the funds.
  • More money for a down payment may equal more options. Borrowing against your 401(k) plan will allow for a larger down payment, which will allow for wider options when it comes to mortgage lenders. It could also help you qualify for a better interest rate as well as help you dodge Private Mortgage Insurance (PMI).

A Note on PMI

PMI is customarily required when you have a conventional loan and make a down payment of less than 20 percent of the home’s purchase price. The most common way to pay for PMI is a monthly premium that is added to your mortgage payment.  Because it protects the lender and not the borrower, many home owners want to avoid this added expense, but some choose to see it as just another expense of owning a home.

Disadvantages of Borrowing from a 401(k)

  • You are diminishing your retirement savings, both in its immediate drop in balance and its future growth potential. Most likely, the return on investment (ROI) you would gain by keeping your money invested would be greater than the ROI from the interest you pay yourself (or the appreciation on your house).
  • Your budget will take a hit. You are required to repay the 401(k) loan, which means that a portion of your future paychecks will go toward repayment. That means less money at your disposal for other expenses, such as homeownership costs.
  • You will be on a repayment deadline. Borrowers typically get five years to repay a 401(k) loan. Depending on the size of your loan, you could potentially face large monthly payments in order to meet the repayment deadline.
  • Inability to repay the loan will result in penalties. Your loan will be treated as a withdrawal if you are unable to pay it back in full by the deadline, which means that you will owe income taxes on it. You will also be subject to a 10% penalty associated with early withdrawals unless you were older than 59 ½ when you took the money out.
  • Beware of the cost of leaving your job before the loan is paid. If you quit your job or experience a layoff, the entire loan amount will need to be paid by the due date for filing taxes that year. This could result in a need to repay the loan quickly in order to avoid penalties.

Why a Roth IRA Might Be the Best Retirement Account for Beginners

One of the easiest ways to start saving for retirement is through a Roth IRA, and some would say it’s the smartest move a beginner saver can make. A Roth IRA could be a better choice than a 401(k) or a traditional IRA for a few key reasons.

Roth IRA: A Primer

A Roth IRA is an individual retirement account (IRA) that permits qualified withdrawals on a tax-free basis provided specific conditions are reached. The greatest distinction between a Roth IRA and a traditional IRA is that Roth IRAs are funded with after-tax dollars. While the contributions are not tax-deductible, this account offers tax-free growth and tax-free withdrawals in retirement. As long as you have owned your Roth IRA account for 5 years and you’re age 59 ½ or older, you are allowed to withdraw your money without owing federal taxes. In 2021, you can contribute up to $6,000 to a Roth IRA ($7,000 if you are age 50 or older and eligible for catch-up contributions). This is lower than the limit for a 401(k) but it’s still a sizable amount to help keep you on track for a secure retirement.

Roth IRA Advantages

  • No RMDs. Unlike 401(k)s and traditional IRAs, which are subject to required minimum distribution (RMD) withdrawals after age 72 (and penalties if you fail to make the withdrawals), there are no RMDs with Roth IRAs, so you can withdraw funds on your own schedule.
  • No time limit. You may invest money into your account for as many years as you have earned income that qualifies. This includes wages, salaries, commissions, and bonuses from an employer. If you are self-employed or in a business partnership, this would include net earnings from your business, less any deduction authorized for contributions made to retirement plans on the individual’s behalf and further reduced by 50% of the individual’s self-employment taxes. Funds pertaining to divorce, such as alimony, child support, or in a settlement, may also be contributed.
  • No employer-plan restrictions. Regardless of whether you are covered by an employer’s retirement plan, such as a 401(k), you are still eligible to contribute the maximum annual amount to a Roth IRA as long as you don’t exceed the IRS’s income limits. For 2021, those with modified adjusted gross incomes (MAGI) below $140,000 (single filers) or $208,000 (married filing jointly) are eligible.
  • No Impact on Social Security. Whereas distributions from a 401(k) or traditional IRA contribute to determining if your Social Security benefits are taxed (that happens once income hits a certain limit), Roth IRA distributions do not. This means that your Roth IRA withdrawals will never affect your Social Security checks.
  • No taxes for heirs. You may pass your Roth IRA on to your beneficiaries, and their withdrawals will be tax-free. (If you inherit a Roth IRA, you are required to take RMDs, but they are tax-free as long as the original account owner held the account for at least 5 years.)

Before You Invest in a Roth IRA

An important element to keep in mind is the 401(k) match. If your employer matches 401(k) contributions, make sure you take full advantage of this free investment money before investing in a Roth IRA.

How to Get Your 401(k) Back on Track After COVID-19

The COVID-19 pandemic has been more than a health crisis—it’s been a financial crisis as well. Business closures, job loss, reduced hours, and limited financial relief led to many savings accounts taking a major hit. As a result, more than 2 million Americans took advantage of the waived penalty for early withdrawal from a 401(k) or other qualifying account set forth in the CARES Act of 2020. This benefit may have been a financial life raft for some, but the move to tap into retirement funds isn’t without short- and long-term impact.

401(k) Early Withdrawal in 2020

Dipping into a retirement savings plan such as a 401(k) before age 59 ½ typically is not without penalty. However, in response to the ongoing COVID-19 crisis, the CARES Act of 2020 made it possible for retirement savers younger than 59 ½ to withdraw, for Covid-related reasons, up to $100,000 from qualified accounts without paying the usual 10% early-withdrawal penalty. For Americans who took a withdrawal, the money is yours and you don’t need to figure out a repayment plan. However, the flip side to this move is that retirement funds you’d planned to live on in the future are now diminished.

Taxes Upon Withdrawal Still Apply

The CARES Act temporarily eliminated the 10% early-withdrawal penalty, but the legislation didn’t pardon the taxes due. While you don’t generally pay taxes on contributions to traditional 401(k)s and IRAs, you do need to report income and pay taxes upon withdrawal. This holds true even though the CARES Act canceled the 10% early-withdrawal penalty for a short time. The temporary rules allow for the distribution to be spread across three years, but you need to account for a least one-third of the taxes due on that amount on your 2020 tax return.

Paying it Back is Recommended

Though you’re not required to pay back this type of withdrawal, experts agree that it’s generally in the saver’s best interest. Doing so allows you to avoid the taxes and to replenish your retirement account. If you pay back the full distribution amount within the three years, you can amend your tax returns and get all the money back paid in taxes.

For those who took a plan loan, you generally have five years to pay it back. You’ll need to be diligent in sticking to the plan’s repayment schedule. A loan that isn’t paid back could be counted as a distribution, therefore taxes (and possibly a penalty) will apply.

Strategize

Savers who took a coronavirus-related distribution have more leeway in developing repayment strategies that best serve their personal situations. Those who took a plan loan have less flexibility, but some repayment strategies could be advantageous, including:

  • A mortgage refinance. Given the current low interest rates, refinancing might save a few hundred dollars a month. That savings could then be redirected to repay the 401(k) funds.
  • A home equity line of credit. Take advantage of low interest rates, with the ability to pay back the line of credit over at least 10 years.
  • Student loans. For savers with college-age children, don’t count out the possibility of relying on federal student loans to help fund college costs while using the freed-up out-of-pocket cash to help pay back funds taken from a 401(k), perhaps in a lump sum. A federal undergraduate loan interest rate of 2.75% through June 30, 2021 combined with conventional thinking that you can borrow to pay for college make a potentially attractive avenue. Just be aware to not overborrow and dig yourself deeper into debt.

Some people may need to apply more than one strategy to return the money to their 401(k), relying on different options that will get them through the next few years. Work with a financial advisor to help determine the best path forward to getting back on track.