using 401k loan for downpayment

[usc_et]

this question is not for me, I swear! I wouldn't do this. A "friend" is currently renting for a little over $1k/mo and by working a weekend job has paid off various debts that she has carried. She emailed me asking about taking a loan from her 401k for her downpayment. I am planning on advising against it, but I want to make sure I have my facts straight.

I'm sure the loan provisions vary by 401k plan administrator, but let me know if you know any of the following:

1. Is interest deductible?
2. The interest being paid is to yourself (as in back to your plan)?
3. How long are the typical repayment periods?
4. How is the rate usually determined?
5. Are there usually fees? How steep?

She said that she is tired of renting and would like to buy a condo. Just for reference, she lives in the San Fernando Valley (Los Angeles Area), and works in Century City. She is single, and is thinking about a condo (presumably because of affordability).

Thanks

 

[nuisance]

I am actually considering this, but I haven't run the numbers yet. All answers are for my plan (which is my company's plan through Meryll Lynch), and just what I got from a read of the quick summary:
1. I'm assuming it isn't.
2. Yes, it's paid to yourself, back into the plan.
3. Up to 5 years, except if you're using the money for a home. The quick blurb doesn't say what the exception is. Note that when you leave the plan (by quitting work, or going to work for a different company) you have to pay the balance right away, or suffer early withdrawal penalties.
4. 1-3% above prime.
5. No fees that I can tell. The main "cost" is that while the money is borrowed, it is not invested in the market.

My main problem is that I don't make enough money to both save for a down payment and max out my 401k. In that situation I think that long term I will end up with more money in my 401k if I max that out and borrow against it, than I would if I saved a down payment outside the 401k by reducing 401k contributions.

Running the numbers for this (and some other stuff) is pending a proper rewrite of my financial spreadsheet.

Tim

 

[vic]

I borrowed from my 401K. It was the best option available for me to get 10K at a low rate (about 4%) with just the click of a mouse button. However, I knew I would have no problem paying it back in a short amount of time. The interest is not deductible but you are paying interest to yourself. I think the biggest drawback is that when you leave the company, the balance is due in 2 months or so or it becomes taxable income with a penalty slapped on top of it. I paid off my 401K loan two weeks before I got booted. For a short term loan I think it works great. To use it almost like a second mortgage is scary. Call the 401K company and check with their policies on the 401K loans, some details may vary with the different providers.

Vicky

 

[Martha]

I'm sure the loan provisions vary by 401k plan administrator, but let me know if you know any of the following:

1. Is interest deductible?
2. The interest being paid is to yourself (as in back to your plan)?
3. How long are the typical repayment periods?
4. How is the rate usually determined?
5. Are there usually fees? How steep?

Many but not all plans allow loans. Once you reach a minimum vested balance (determined by the plan), you may be eligible to take a loan from a 401(k) account. Repayment takes place through automatic payroll deduction. The interest amount is set by the plan, so your friend should check with her plan administrator. Usually fees are minimal.

She will lose out on the earnings growth that would have occurred if the loan amount were still in the plan. Additionally, unlike some loans, the interest payments on 401(k) loans are not tax deductible. There are usually restrictions, including those on loan frequency and loan amount. She will have to check with her plan sponsor for more details.

 

[KB]

For repayment, you use after tax dollars and then later on in retirement you are taxed again when removing the money.

Also if employment is terminated, the money has to be repaid within a specific amount of time or be taxed with penalty. The time frame is 30 - 90 days or so.

It might be a good solution, but with risk.

 

[Outtahere]

You might want to check on the interest not being deductable. I took a loan from my 401k to buy an investment, my CPA told me it was deductable so I would check with your accountant.

Cj

 

[brewer12345]

Personally, I think your friend must be high to want to jump into the LA real estate market right now, especially with no downpayment and (presumably) limited financial resources. However, if she is hell-bent on the idea, I would find a different source of financing. If she has good credit (FICO of 720 or better), she should be able to get a piggy-back loan combo. Under this deal you get a foirst mortgage for 80% of the purchase price and then a HELOC for up to the next 20%. Much more flexible, much less draconian pay-off schedule, and the interest is deductible.

 

[usc_et]

Personally, I think your friend must be high to want to jump into the LA real estate market right now, especially with no downpayment and (presumably) limited financial resources. However, if she is hell-bent on the idea, I would find a different source of financing. If she has good credit (FICO of 720 or better), she should be able to get a piggy-back loan combo. Under this deal you get a foirst mortgage for 80% of the purchase price and then a HELOC for up to the next 20%. Much more flexible, much less draconian pay-off schedule, and the interest is deductible.

I feel the same way. She trusts me in money matters, so instead of just telling here, "Girl, you crazy!" I'm going to let her know how high prices are and how much of a burden buying would be. I'll give her the pros and cons, and ultimately it's up to her.

 

[SteveR]

I would say it all depends on how old she is, when she would like to retire, and how much she wants to retire on when she does retire.

Robbing your 401(k) at an early age may not seem like a big deal but look at what effect it will have 20+ years down the road. How many more years of income will she losing by doing this? How much longer will she need to work to make up the difference? Is it worth it for her?

My SIL has a spending problem and is blind to the future. I gave him my "so, do you want to work the rest of your life?" speach. He is still unimpressed but I keep hoping he will see the light and realize he is losing out on the best chance at ER or even a comfortable R later in life by the future value of money invested for a longer time. He cannot make up the difference he will lose by not saving and investing now.

 

[TromboneAl]

She says she's tired of renting but I'll bet that what she's really tired of is hearing how everyone from the pool boy to the mailman (sorry, pool person to the mail carrier) has seen his/her condos' value appreciate through the roof.   She's going to jump in at the top, and there's nothing you can do to stop her.

 

[Martha]

You might want to check on the interest not being deductable. I took a loan from my 401k to buy an investment, my CPA told me it was deductable so I would check with your accountant.

Cj

Uh, I don't have the tax code and regs right in front of me, but I am pretty confident 401(k) loans even if secured by a home mortgage are not deductible. If I were you, I would have your CPA check again about deducting your 401(k) interest used to buy an investment. I don't think any 401(k) interest expense is deductible because the interest is paid to you.

 

[Outtahere]

Martha, I did that 5 years ago to purchase my investment, the CPA that does my personal taxes and the companies taxes told me it was deductable, it could be the kind of investment I bought into. It's definately something I would check out with a CPA before I jumped in.

Cj

 

[usc_et]

Martha, I did that 5 years ago to purchase my investment, the CPA that does my personal taxes and the companies taxes told me it was deductable, it could be the kind of investment I bought into. It's definately something I would check out with a CPA before I jumped in.

Cj

What you use the money for should never be a factor in determining the deductibility, just the type of loan. A mortgage, home equity loan, a business loan, maybe margin debt? I'm pretty sure if you borrow money, regardless of how that money is used it is based on the type of loan.

For example, you could take out a second mortgage to buy a Mercedes. The interest would be deductible. You can take out an auto loan, and it would not be. You can max out your credit cards to put down a downpayment on a condo and it would not be deductible. You can take out a second to get the downpayment money and it would be deductible.

 

[BigMoneyJim]

I took a loan out. My plan allows up to 50% of balance to be loaned with a minimum amount...$1000 maybe? There's a $100 loan fee, and my plan says I can't make another loan until a year after the last one is paid off.

A general loan could be paid back in 5 years, a loan for a house could be paid back in 10 years. I don't recall if I could shorten the payoff terms, but I know I couldn't pay extra now and then...I was allowed one extra payment during the term of the loan. Naturally I'd save it for a lump sum payoff.

Many years ago I borrowed about $3k--half my balance at the time--on a general loan but planned to use it for a home down payment. The house deal fell through, but I had managed to fritter away enough of the borrowed amount that I couldn't pay it back immediately as I had envisioned in case the deal fell through. I was disappointed in myself but apparently not disappointed enough to save up and pay it back because I paid it out over 5 years.

That was 5 of the strongest growth years, and my account soared. I've never tried to calculate how much more I would have if I had paid it back immediately or not made the loan in the first place, but I suspect it's a lot...20% to 40% more money today maybe. (And recall I wasted the money instead of investing it elsewhere.)

Echoing the above, the opportunity cost is a biggie, and losing/quitting the job triggers a hefty tax penalty if you can't pay the loan back in a lump sum.

Something I didn't see mentioned above is that the 401(k) loan didn't show up on my credit reports. (Read around the grammar issues there...) I guess that could be an advantage or disadvantage depending on what you have in mind.

 

[Sisyphus]

I'm surprised more people aren't more vocally opposed to this... especially on this board.

Beside the point of wanting to get into the LA market at the current time, all you need to consider is the following and most people would decide NOT to borrow from 401K:

- The money you put in there was PRE-tax. Almost like getting a 30% bonus right there (depending on your tax bracket).
- When you take it out, you need to pay it back in a limited time or you get smacked with some SERIOUS penalties.
- If they reduce their 401k contribution to get the "extra cash" for the payback, they are missing out on the match (I've heard of several people doing this). Where do they plan go get the payback money?
- When you pay it back, you do so with AFTER tax money. There goes 30% out the window.
- When you take it out again upon retirement, you PAY income tax on it again (assume another 30% there... Lord only knows how much higher taxes will be in the future compared to now).

Imagine that property values could go down, and you have an even more scary picture.

If, in fact, the person was saving in a 401K with the intent of retiring someday, I would strongly advise them to leave the 401K alone!

Good luck!

 

[Martha]

The discussion about whether interest is ever deductible on 401(k) loans has been bugging me so I looked it up. The issue applies both to home loans where the loan was from a 401(k) and loans taken from a 401(k) for investment purposes.

The applicable section of the Internal Revenue Code is 72(p). This section sets forth the rules regarding qualified retirement plan loans. Section 72(p)(3) has two rules that will in most cases deny the borrower any deduction for interest paid on a 401(k) loan, even if the loan was used for investment purposes or to acquire a home.

One limitation is that there is no interest deduction if you are a key employee. A key employee is defined in the code, with the definitions based on factors such as the amount of compensation and whether the employer is an owner or officer of the company.

The second limitation is for 401(k) loans "secured by" elective contributions from the employee. If so, the interest is not deductible. The code requires all qualified plan loans to be adequately secured. Most if not all loan programs provide that the employee's 401(k) account balance is the security. If the employee's account balance had any contributions from the employee in it, no interest is deductible on loans from that 401(k).

Inotherwords, interest on a 401(k) will only be deductible if you were not a key employee AND all the contributions securing your 401(k) loan were employer contributions.

What if you secured your 401(k) loan not with your contributions to the 401(k) but by your house? From what I can tell, this is not the practice. Most often home loans are not secured by a mortgage at all or are secured by a mortgage and the employee's account balance, thus the interest most likely will not be deductible. In fact, most authors presume interest on 401(k) loans is not deductible, with only a few authors even mentioning the possibility of deducting interest on loans from accounts where the balance is totally from non-elective employer contributions.

So it looks like interest on a 401(k) loan (and also 403(b) loans) is rarely deductible.

Do not take this as legal advice but as issues to look at if you are borrowing from a 401(k) and want to deduct your loan interest. Also, rules changed somewhat in 1996 so if your loans predate that time period, don't assume you did something wrong.

You can read about some of this in IRS Publication 575, but the language is dense. I had to actually read the statute.

That will be $250.

 

[usc_et]

That will be $250.

What a bargain! Well, in that case I have a few more legal/tax questions....

Nah, just kidding.

 

[BigMoneyJim]

Inotherwords, interest on a 401(k) will only be deductible if you were not a key employee AND all the contributions securing your 401(k) loan were employer contributions.

(Emphasis mine) From reading the rest of your post I assume that should say "employee contributions"?

Thanks for looking it up! Check's in the mail.

----------

By the way, I'm not encouraging 401(k) loans. My experience is an example of what not to do.

 

[Martha]

(Emphasis mine) From reading the rest of your post I assume that should say "employee contributions"?

No. The interest is deductible if you have only nondiscretionary employer contributions in your plan AND you are not a key employee.

 

[usc_et]

And this is the problem with deductibility and why most advisors and web sites take it for granted that it is not deductible. It is extremely rare (I have never heard one instance of it) for an employer to contribute to employee's 401(k)s without any employee contribution.

 

[HFWR]

Au contraire...

In lieu of a DBP, "my" megacorp contributes 2%.