In a United States context, you might have heard people talking about “borrowing from their 401 (k)”. But what does this mean? Keep reading, and we will straight out some question marks about this practice.
What is a 401 (k)?
In the United States, a 401 (k) plan is a company-sponsored retirement savings plan for employees. It is not mandatory and not all companies offer this for their employees.
The 401 (k) retirement savings plan is named after a section of the U.S. Internal Revenue Code (IRC).
The 401 (k) has tax advantages for the saver, but only if certain rules are adhered to.
The employee who signs up for a 401 (k) plan will have a percentage of each pay check deposited directly into the retirement account, and the employer may match part or all of the amount.
The employee get to select how the money in their 401 (k) is invested, but not completely freely, because the employee can only chose among certain approved alternatives.
It is very common for people to have their 401 (k) savings invested in mutual funds.
What is Roth?
There are two basic types of 401 (k) retirement plans: the traditional one and the Roth. The chief difference between them pertains to how they are taxed. With a traditional 401 (k), employee contributions are pre-tax and thus educe the employees total taxable income. Tax is paid when withdrawals are made in the future. With a Roth 401 (k), employee contributions are made with after-tax income and there is no tax deduction in the contribution year. Future withdrawals are tax-free, if the rules are adhered to.
Special Covid19 rules for 401 (k)
The CARES Act includes special provisions for those affected by the Covid19 pandemic. The special provisions impact several parts of the law, including the withdrawal rules (by relaxing them) and the required minimum distributions (they were suspended for a period of time). The CARES Act also increased the amount that can be borrowed. For more detailed information, visit the irs.gov.
Borrowing from your 401 (k)
It is permitted for employer to allow their employee to take out a loan against their 401 (k).
Important: If you leave the employment before the loan is repaid, you must either repay the loan in a lump sum right away or it will be considered an early withdrawal and will incur the 10% early withdrawal penalty.
Borrowing from a 401 (k) to purchase a home
The law normally requires 401 (k) plan loans to be repaid on an amortizing basis with a fixed repayment schedule that can be no longer than 5 years. There are, however, some exceptions to this requirement, and one of those exceptions pertains to buying a primary residence. In essence, the law makers have made it fairly easy to use a 401 (k) loan to borrow money when you need to purchase a home to live in. There are several requirements that must be fulfilled for this to work out correctly, so make sure you check the details with the IRS before you make any decisions. If the requirements are fulfilled, you will be permitted to use a longer payback schedule than the normal one.
Is it good idea to borrow against your 401 (k) to purchase a home? That depends on the circumstances. For starters, it is important to understand all the tax implications. One of them is that while most types of normal mortgage loans qualify you for tax deductions for the interest payments, 401 (k) plan loans do not.
One of the reasons why many people opt to use a 401 (k) loan to find funds for things such as down payment and closing costs is that it is technically not debt. Borrowing against your 401 (k) does not impact your debt-to-income ratio, and will therefore not decrease your ability to qualify for a standard mortgage loan. Using a 401 (k) loan can also be beneficial from a credit score perspective.