401k loan for house down payment

[RDamien]

I'm going to pose this question verbatim how it was asked of me by my younger brother. I dont know his financial details but he is single, 30, and rents currently. He has a good job but I dont know his income or how much he has in his 401k.

His question:

"What's the down side of borrowing against your 401k as a down payment on a house? (Besides the lost interest)"

I really dont know the answer. I've been advising he look for a house or condo as opposed to renting. Is that wise advice?

 

[sarahsays]

In some plans (if not all) you can't make contributions to the 401k until you have repaid the loan. So, depending on how much he takes out from his 401k, it could be years before he has repaid the loan and can make further contributions.

 

[Rustward]

Not an expert in this area but my understanding is if the job ends while a loan is outstanding, the entire loan amount becomes due in a relatively short period of time, something like 60 or 90 days. Not sure what happens if you are unable to repay it during that short period. I would think at that point it might be treated as an early withdrawl with the 10% penalty and taxed as ordinary income.

The loan must be repaid with after-tax money. In other words, the loan amount is taxed twice: first when the loan is repaid (because it must be repaid with after-tax money), and again in the distribution phase of the 401k.

Perhaps there are some exceptions for first-time home owners...

 

[RDamien]

Ok thanks for the advice. So it's not optimal obviously. I'll ask him to look into any penalty exceptions for home down payments.

 

[jIMOh]

I have taken 2 401k loans for the two properties I bought.

Property 1 was a condo, I foolishly financed it for 8 years. My last payment on that loan was last month.

Property 2 was the house I live in now, I learned from mistake 1 and financed it for 14 months (shortest period allowed by plan).

I still contributed to 401k in both cases.

In first case I took loan 1 in early 2000. The market crashed a few months later. Looks like a good move in hindsight. Loan 2 was repaid over such a short time it does not matter when it was taken.

If you take a loan
1) keep repayment period as low as possible (reduces risk of getting downsized)
2) lower bond position as the loan behaves like a bond in 401k
3) do not take loan out at bottom- it will really hurt long term returns
2)

 

[camefromnothing]

Rustward is right on the money. I used to manage the affairs of my last employer's 401k Plan.

 

[WanderALot]

The loan must be repaid with after-tax money. In other words, the loan amount is taxed twice: first when the loan is repaid (because it must be repaid with after-tax money), and again in the distribution phase of the 401k.

I don't think 401(k) loans are a particularly good idea, but I'm not sure if this "taxed twice" is really the case. Let's say I choose to take a 5k loan from my 401k. The 5k is untaxed money and let say I use it to buy a car. I've effectively bought that car with with untaxed money. Then I pay back the loan (plus interest) with after-tax money (which is then taxed "again" during the distribution phase). Effectively, it's a wash since I purchased the car with "tax-free" money and paid back my loan with after tax money. To me, it looks like, at worst, the *interest* paid back to my 401(k) on the 5k is what is taxed twice, not the 5k principal.

What am I missing here?

 

[fireby40]

Like most everything else to do with 401Ks, I don't think many of the details are consistent between plans. Bottom line is you need to read the fine print for your specific plan.

With my company (401K managed by CitiStreet) loans have zero impact on your account balance or contributions. It just treats the 401k balance as collateral if you try to split without fully repaying the outstanding balance. Only in this scenario would you be hit by a tax penalty.

 

[CitricAcid]

WanderALot, that may be the case. In your example, however, if you were able to pay the loan off tomorrow (with ZERO interest payments), you would have gotten the 5000 from the 401k to pay with pre-tax money but would need to immediately pay back 5000 after tax (which is 6500-7000), so it is an almost immediate tax on your in the loan. You are then again taxed on the money when you withdraw eventually so Rustward's explanation is accurate.

 

[mathjak107]

only the interest you pay to yourself on the 401k is taxed 2x. the principal you pay back is only taxed once. your putting back the same tax deferred money you borrowed back out in effect . its a fallacy its taxed 2x. its paid back the same as any other loan. with money you have to pay tax on in any case. whether you borrow from a bank or your 401k they are always paid with money thats earned income and has to be taxed , . most loans are only for 5 years and if your company folds its all due back in full. think of it this way. you took 50 grand from your ira as a loan. you decide not to use the money. you put it back. its still untaxed money ....

 

[mathjak107]

easy example: you earn 80,000 a year income, you put 20,000 in a 401k. taxable income is 60,000.... you take a 20k 401k loan,,, you pay it back at years end from your earned money. taxable income still only 60,000. in fact its 60,000 even if you took no loan. wish susie orman would read this! the 20k will be taxed later on at withdrawl 1x

 

[jIMOh]

easy example: you earn 80,000 a year income, you put 20,000 in a 401k. taxable income is 60,000.... you take a 20k 401k loan,,, you pay it back at years end from your earned money. taxable income still only 60,000. in fact its 60,000 even if you took no loan. wish susie orman would read this! the 20k will be taxed later on at withdrawl 1x

That 20k was used to pay back the loan, so it was already taxed before repaying the loan. The money was taxed twice. Once on loan repayment and second time on withdraw.

 

[tryan]

All loan payments are after tax ... so whether its taxed 2x is a non-issue (assuming you'll borrow from another source - if not yourself).

 

[BunsGettingFirm]

All loan payments are after tax ... so whether its taxed 2x is a non-issue (assuming you'll borrow from another source - if not yourself).

Yes, but I won't be able to say, "Blood sucker!" with the same vehemence.

 

[WanderALot]

All of this is making my head hurt! I think I'll solve this problem by resolving to never take a loan from my 401(k) so that I'll never have to think about this!

 

[mathjak107]

That 20k was used to pay back the loan, so it was already taxed before repaying the loan. The money was taxed twice. Once on loan repayment and second time on withdraw.

nope, since you pulled the money out that was tax deferred you merely are swapping it with the money that you earned that is taxed anyway. think about it at what point are anymore taxes paid because you took a loan. you still only pay based on 60,000 out of the 80,0000 you earned and you pay on the 20,000 when you retire and withdraw it. at no point is your tax bill any higher if you take a 401k loan than if not. its identical

 

[Darryl]

Also have head hurting. Don't see the 2X I only see 1X. Biggest risk as mentioned by Rustward if you lose your job loan is called and if you fail to pay it is an early withdrawal subject to taxes and penalties at the same time your income went to zero hope you have a big enough emergency fund to cover all this (of course if you have that big of an emergency fund you have enough cash to not have to borrow from your 401K).