Borrowing from your 401(k)

If you have a 401 (k) you might be able to borrow money from yourself. In some situations, borrowing money from ones 401 (k) can be a sound financial decision, but it is never one to be taken lightly. Before you go ahead, make sure you understand the pros and cons, and how to avoid the pitfalls.

What is a 401 (k)?

A 401 (k) is a company-sponsored retirement savings plan available in the United States. It is not mandatory for employers to offer this plan and not every employer do. It is also not mandatory for an employee to agree to a 401 (k) even if it is offered. If an employee does sing-up for a 401 (k), a percentage of their pay will automatically go to the 401 (k) savings account, which can have certain tax advantages for the employee. The employer can elect to match part or all of the deposited amount.

What happens to the money in the 401 (k) account?

The employee gets to chose from many different approved investment alternatives. It is very common for employees to invest their 401 (k) savings in mutual funds. Hopefully, the investments will turn out well and there will be a lot of money in the account when it is time to retire and start withdrawing.

Borrowing from your 401 (k)

It is permitted for the employer to allow the employee to take out a loan against the 401 (k) savings. In essence, the employee will be borrowing their own money.

If you are an employee and are considering borrowing money from your 401 (k), it is important that you make an informed decision. You should for instance be aware that the loan must be repaid according to the IRS rules (usually within 5 years). If you leave the employment before the loan is repaid, you will have to repay the the loan right away. If you fail to repay the loan right away, it will be considered an early withdrawal instead, and you will be forced to pay the 10% early withdrawal penalty.

The CARES Act

The CARES Act was created to help those impacted by the Covid19 pandemic and includes special provisions for 401 (k) savings plans. Some of these provisions pertains to borrowing from a 401 (k) and are therefore of interest if you are planning to borrow money from your 401 (k). Among other things, the CARES Act makes it possible to borrow a larger amount than what the standard rules stipulate. If you want to know more, visit irs.gov.

Borrowing from your 401 (k) to buy a primary residence

You might not have enough in your 401 (k) to buy a home outright, but tapping into your retirement savings can still be helpful when you need to come up with money for a down payment and closing costs.

If you borrow from your 401 (k) to purchase a primary residence, you can benefit from certain special rules that do not apply to someone borrowing money from their 401 (k) for any other reason. Example: The normal requirement is to pay back the loan within 5 years, but if you are borrowing to purchase a primary residence you can be approved for a longer repayment period.

There are a lot of requirements that must be fulfilled and rules that must be adhered to for this to work out well, so make sure you check with the IRS in advance to avoid getting yourself into financial troubles.

It is worth remembering that when you borrow money from your 401 (k), it does not impact your income-to-debt ratio. This can be good to keep in mind when calculating how large of a house mortgage loan you may be approved for.