Large Life Purchases: Is Using a 401(k) Loan a Good Idea?

Are you thinking of making a big purchase, like buying your first house, but you’re uncertain how to fund a down payment?

If you haven’t been able to save enough to swing the costs for a big purchase—something that might require tens of thousands of dollars—what are your loan choices?

If you have a 401(k) with a sizable balance, you could consider taking out a 401(k) loan. But before you do that, be sure to weigh the potential benefits and costs of tapping your retirement account.

Everyone’s situation is different, but here are some general tips to help you if you want to start thinking about taking out a 401(k) or 403(b) loan.

Know the Terms

According to Josh Alpert, owner and president of Alpert Retirement Advising in Southfield, Michigan, there are two reasons why most people take a 401(k) loan: to fund a big life purchase, or because they’ve had some sort of hardship and need access to cash. In general, a loan can be up to 50% of the vested balance, as much as $50,000.

There are pros and cons to taking out a 401(k) loan for a major life purchase. Two of the biggest pros are that the money is easy to access and there’s no credit check needed. “You don’t have to go through a bank, and it’s a quick process. Once you’ve drawn out the money, you have about a five-year period to pay it back,” Alpert said. “And if you borrow to purchase a home, that five-year period can be stretched.”

Borrowing from Yourself = Paying Yourself the Interest

Loan rates can be low; many loans are calculated by using the prime rate, plus 1%. Because it’s a loan, as long as you keep current on the payments, it’s not subject to the 10% penalty for early withdrawals (see Avoid Missed Payments below). And, unlike when you borrow money from a bank, you’re paying the interest to yourself, which might make those interest payments a bit more palatable.

But you can’t just smash your 401(k) piggy bank, take the money, and think you’re done. There are 401(k) loan rules that must be followed to avoid hefty penalties. And there are downsides to taking a 401(k) loan.

Watch Those Fees, and Avoid Missed Payments

Although you have five years to pay back the loan, repayments start right away after you take out the money. (The money is usually deducted from your paycheck by your employer.) There may also be fees involved in taking the loan. 

According to Alpert, if you miss a loan payment after 90 days, it may go into default, and the full value of the loan becomes taxable. If you’re younger than 59 1/2, you’re also subject to a 10% Internal Revenue Service tax penalty.

For loans taken before 2018, if you lose or quit your job during the payback period, then the entire amount usually has to be repaid in 60 days. If it’s not, then the loan goes into default, the outstanding loan balance becomes taxable, and the penalties for those under 59 1/2 apply. For new loans taken after January 1, 2018, workers have a little more time to payback an outstanding loan once they stop working. When you leave a job, you have until October of the following year (the due date of your tax return on extension) to put the money back into your 401(k) or to roll the outstanding loan balance to an Individual Retirement Account (IRA).

And remember, if you withdraw funds from a 401(k), it also means that money can’t grow for your retirement (aside from the interest you’ll be paying yourself). Your account balance is actually liquidated to pay you your loan.  

There are alternatives to cashing out a 401(k). You could take out an IRA withdrawal, and there’s no need to repay it. But unlike the 401(k) loan, the money will be taxable immediately. Plus, if you’re under age 59 1/2, you’ll incur a 10% penalty for early withdrawal. Alternatively, you could withdraw contributions made to your Roth IRA, as long as you don’t withdraw your earnings or recently converted balances (amounts converted within the last five years), your withdrawal will be tax-free, even if you have not had the Roth account for five years and/or are under age 59 1/2. But be careful if you do withdraw earnings or converted balances because taxes or penalties could apply. In this case, taxes and penalties might apply if you’re under age 59 1/2 and have not had the Roth IRA for five years, or if you did the Roth conversion less than five years ago.

The upshot? A loan from your 401(k) can be a viable choice if you’re looking for cash to help fund a big purchase. But if you think you might be leaving your current job soon, or you’re not willing to sacrifice the potential growth of your retirement savings, you might want to think twice before proceeding. 

Remember you can borrow from a bank for a house or even a child’s education expenses, but you can’t borrow from the bank to fund your retirement. Before making a final decision, consider working with a tax-planning or financial professional to understand the potential impact a 401(k) loan could have on your retirement savings and tax bill. 

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.