- Okay, did you know that you can borrow
against your 401K to make a large purchase?
Maybe you're in a bad financial situation
and you need the money right away.
Maybe you are wanting to use the money
to pay for a home.
In either scenario, borrowing against yourself
could be harmful.
So here's the good, the bad, the ugly about 401K loans.
(soothing music)
Hey, guys, welcome back to The College Investor:
Investing & Personal Finance for Millennials.
So 401K loans, basically, you know what a 401K is.
It's your employer's retirement plan,
and you are more than likely saving up that money
so when you retire, you have money to live off of.
And sometimes you are making some large purchases
before you retire and you might be looking
at borrowing against your 401K to pay for that purchase.
One thing that we should make clear up front,
there is a difference between a 401K loan
and a 401K withdrawal.
So a 401K loan means that you are borrowing
against yourself and typically you can borrow
up to $50,000 or half of your investment account,
whichever is less, and then you have to repay that money,
typically over the span of five years.
You'll also, when you repay yourself
over that five year period,
you'll also be paying yourself interest.
With a 401K withdrawal, it means you are pooling money
out of your 401K with no intentions
of ever repaying that money back.
If that's the case, and you're withdrawing that money
before the age of 59 1/2, you will have to pay income taxes
on that money and a 10% penalty fee.
Now, there are a few exceptions to that.
If you are a first-time home buyer
and you are looking to add more cash
to your down payment, you can withdraw from your 401K
up to $50,000 or half the amount
of what's invested in that account,
whichever is less, without incurring that 10% penalty fee.
Of course, you'll still have to pay it back.
But it is a way for first-time home buyers
to increase their down payment amount.
The second way is, as of March 27th, 2020,
in the CARES Act due to the coronavirus pandemic,
investors were allowed to withdraw up to $100,000
from their 401Ks without incurring that 10% penalty.
But back to the 401K loans,
I mean, you're borrowing against yourself
and then you're paying yourself interest,
so it can't be all that bad, right?
You're just dealing with you.
So a way that you could work this to your benefit
if you overpaid in your retirement.
So you have tons and tons of money
in your retirement account,
which means you don't really have a lot to pay
for short-term purchases, like maybe a car,
maybe somebody's wedding, education, that sort of thing.
You can use that money if you have a lot
in your retirement account as it is.
The second way is you can use it
to top off a down payment.
If you don't have a ton of cash
or maybe you've been saving for a down payment,
but you'd really like to bolster it a bit,
you can use some money from your 401K to top it off.
In addition to that, you can use a 401K loan
as a bridge loan.
So this also has to do with real estate investing.
If want to use that money to pay for a new house
and you're still working on selling your old house,
this is a way for you to get into that new home faster
while you work up sprucing your old home.
So you're basically just shuffling money around
so that you can free up money
from the sale of your old home,
repay yourself into that 401K loan,
and then you're into this new home.
It's a lot of moving parts,
but that's basically one way you could do it.
The last way that you could use a 401K loan
to your advantage is to pay off high-interest debt.
If you have credit card debt
and you don't qualify for a balance transfer,
then you could use a 401K loan
to pay off the high-interest debt,
then go back to repaying yourself
through the 401K loan with a lower interest rate.
But here's the thing, a 401K loan is debt.
It's still debt.
It's still debt that you have to pay back.
It's still money that you owe.
So the bad thing about a 401K loan
is that the repayment is made with after-tax dollars.
A 401K account, you use pre-tax dollars to contribute to it,
but when you're in a repayment period against your 401K,
you're using after-tax dollars
to go back and repay yourself.
Also, you're not eligible on your employer match,
so there's no matching period
when you are repaying a 401K loan.
So the third thing that makes 401K loans bad
is that you can't contribute to your 401K
during the repayment period.
In other words, you can't have that pretax contribution
and the repayment at the same time,
which means you could miss out on your employer's match.
And lastly, you just lose time in the market.
When you withdraw that money,
when you take out a 401K loan,
that money is no longer invested,
which means you're no longer getting those returns
like you were when the money was invested.
So you end up losing out on potential gains
in that investment account.
For the most part, 401K loans are like any loan.
You need to be very cautious
and understand what the consequence are
if you don't repay this loan.
Now, here's the ugly.
Here's the ugly truth about this.
If you lose or leave your job and you had a 401K loan
through your employer, your loan amount is due
by that following tax return deadline, April 15th.
If that doesn't happen, then any amount remaining
is subject to taxes and that penalty fee.
Now, this can be especially difficult
if you have that money tied up in real estate
and you can't really get liquid cash
to pay off that loan.
This could set up for a lot of additional headache and fees,
and you just don't wanna deal with that.
The second ugly truth about 401K loans
is that you could end up using this
as a revolving line credit or as an emergency fund.
But here's the thing, 401Ks are
not short-term savings accounts.
This is your livelihood during your retirement
that you are borrowing against from,
which can be really harmful and detrimental.
Most of the time, you wanna keep money in your 401k
as much as possible to let that grow over time.
If you find yourself continuing to go back
to a 401K loan over and over again,
you'll have to go back to your spending and your income
and take a look at what's going on month-to-month,
and see where you can budget and start streamlining things
to create better balance.
The third thing is if you can't pay back your loan,
you really put yourself in a tough predicament.
You will be subject to those tax and withdrawal penalties,
and it's just not good.
At the College Investor, we're all about ways
to grow your money and invest it, not borrow from it.
Ideally, you'll have the cash saved up
for these types of purchases.
You'll have an emergency fund put into place
for emergencies like job loss or unexpected expenses,
and you'll have a savings account,
high-yield savings account or a brokerage account
to help you pay for a car or a down payment
or education expenses.
Whatever it is, you can build in these savings
into your monthly financial habits
so you don't ever have to look at a 401K loan.
They're just not a good idea.
Carefully consider your options before stepping
into a 401K loan.
Now, if you want more ways to practically
save for a large purchase or invest your money wisely
to build that wealth, be sure to check out
all of our free resources at thecollegeinvestor.com.