Moneymentals | Our Blog
- Created on 12 December 2012
- Written by Michael Goldman
Option of Borrowing
Whether or not you can borrow from your retirement plan to purchase a home depends on your plan and your employer.
Borrowing from 401(k) or 403(b) Plans
Most often, 401(k) retirement plans are offered by private employers and 403(b) retirement plans are offered by non-profits. If you have a 401(k) or 403(b), IRS regulations permit you to borrow for a home as well as other purchases. However, the option for borrowing is established when the particular plan is set up. Many employers’ plans do allow for borrowing.
Borrowing from 457 Plans
Typically offered by federal, state or municipal government entities, 457 retirement plans are also available to those who serve in the military or work for certain non-profits. The rules for 457 plans are different from the rules for 401(k) or 403(b) plans. When it comes to borrowing, 457 plans are so strict that you can’t borrow from them without an unforeseeable emergency.
The IRS’s definition of “unforeseeable emergency” is very stringent. For instance, such an emergency might be the illness or death of an immediate family member, imminent eviction from your primary home or a natural disaster. IRS regulations specifically indicate that purchasing a residence or using the funds for educating children is not considered an unforeseeable emergency.
This means borrowing from a 457 plan to buy a house is not an option. However, if you primary residence was blown away by hurricane Sandy, you might be allowed to borrow from your 457—but only due to the fact that the hurricane was a natural disaster. Because of subtle issues related to tax-law interpretation, the final say belongs to the IRS. Therefore, it’s best to consult a knowledgeable CPA on this issue.
Advice for Borrowing
You’re ready to go bungee jumping—but is it a good idea? When you borrow from your 401(k) or 403(b), you’re essentially taking out a loan against your account balance. Instead of taking out a loan from a bank, you’re taking a loan from yourself. That seems appealing. You assume the lender’s risks and the interest goes to you, not the bank. What could be wrong with this idea?
Borrowing from your retirement plan has several problems:
• Added fees: Depending on how your plan is structured, you might pay fees to take out the loan.
• Missed growth for your nest egg: The value of investing in a 401(k) or 403(b) plan is that your money grows tax-deferred year after year, accumulating over time. Though you’re paying your loan back, meanwhile your investment misses out on accelerated growth. Borrowing defeats one of the biggest purposes of putting the money away. Remember, your 401(k) or 403(b) plan is intended to be a retirement plan. That’s financial freedom! Pulling money out delays freedom.
• Potential for taxes and penalties: If you can’t make a payment back to yourself and default on the loan, it’s treated like you took a distribution from your plan. You’ll owe taxes as well as penalties if you’re under 59 ½.
• Danger of sudden payment-in-full: If you and your employer part ways, often the rules dictate that any outstanding loan from your plan is due immediately. You may have to pay it all back at once—when it’s tied up in the down payment on your house. What a sad scenario! You’ve lost your job and can’t pay back the loan, so it’s treated as a distribution and you owe taxes and penalties at exactly the moment you’re short on cash.
If you ignore the red flags and want to take the leap anyway, see if your plan allows for borrowing. Often you can borrow up to a percentage of your balance. Typically, it’s 50%. You’ll make payments to replace what you borrowed, usually as a deduction from your paycheck. Payments include interest, and the total goes back into your 401(k) or 403(b).
The Best Solution
I recommend delaying a home purchase and saving for that down payment over time. You could also borrow funds some other way. Retirement plan loans are self-defeating and risky, so watch someone else bungee jump while your feet are on solid ground!