Hey there, it’s John from Downs Capital. And today we’re talking about your 401(k).
You know, this question usually starts one of the following two ways. John, I have a 401(k). What do you think about borrowing those funds to buy my house? Or, John, I have a 401(k) but I don’t even want to talk about it. It’s not an option. The money is staying there. But what really does this mean? You know, there are two ways to take out money from your 401(k). One is a distribution and the other is a loan.
A distribution is when you take your money out completely and you never plan on paying it back. Generally don’t do this. Unless you have a personal emergency and your hand is forced. To give you an example, if you pulled out $10,000 as a distribution, you could pay up to $3,000 in taxes and penalties. Very expensive.
The other way is to actually take a loan. In this scenario, you’re basically borrowing your own money from your 401(k) and promising to pay yourself back some interest over time through your paychecks.
So, back to the question. Should I borrow from my 401(k)? Well, the answer is, it depends. You know, generally speaking I’d like to see you keep your money in your 401(k) as much as possible. So I’m going to ask you things like, are there other things you can do to buy that house? Such as lower down payment options? Maybe a family gift. But if not, let’s look at your 401(k).
When making this decision, there are three important things to consider. Market conditions are extremely important. If you were considering borrowing from your 401(k) in 2014-15, that was a great time to pull your money out of the market and reallocate it toward something else. But in 2009 not a great time, because the market was, pardon my French, in the toilet.
If you pull money out at a low point, you totally miss the upside swing of the market as opposed to pulling it out at a high, where the market potentially could dip. At least you know when you pull that money out and you place it into a house, your money is still working for you.
You constantly have to take a look at the market dynamics for both stocks and bonds, which is your 401(k) investments, as well as housing. Another thing to consider is the payback period. We do want to get that money back into your 401(k) sooner than later. So you can start taking advantage of the compounding interest, effects of market returns. Personally I don’t want to see you keep it out too long because it can really damage your retirement future.
The last and most important are the taxable events. Now what if you do borrow that money and let’s say you had a job situation where you took a promotion, went to another company or relocated? Would leaving that job or losing create some type of taxable event? Absolutely something you have to look for. I’ve had several clients take a 401(k) loan and then took a new job. But when they left their previous employer the rules for their 401(k) dictated that it had to be paid off immediately. And if not, they would pay taxes and penalties on the outstanding balance. Could be very substantial.
So, 401(k) loans are not for everybody but they are a very useful tool that I’ve seen used quite successfully time and time again.
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