If you work for a company, then you probably have some kind of company sponsored retirement plan. It may be in the form of a 401k or a 403b and over the years you may have contributed a pretty sum of cash. Cash that you can’t touch without incurring hefty fees until you’re at least 59 1/2 years old. For some of us, that’s a long ways away.
Well, there’s a way you can access some of that cash without being hit with those early withdrawal penalties and you don’t have to wait till retirement age! I’m talking about borrowing from your retirement account.
For simplicity sake, when I refer to your 401k retirement account, the same applies to a 403b as well.
Who May Benefit from a 401k Loan?
If you’re planning to borrow from your retirement account to purchase a shiny new car, this post is not for you. In fact, just close this webpage and move on. Though if you’re looking to reinvest the borrowed money, then please keep reading.
I’m not a big fan of investing in the stock market and I’d rather put my retirement money to better work by funding my real estate investments. So if tapping into my retirement account can get me into an additional deal or 2 that returns 10% or more, then I’m all for this option.
If you’re looking for a cheaper option to fund your rehabs, then the 401k option is also for you. A hard money lender will likely charge over 10% interest on a loan with additional points to be paid up front. Instead, you may be able to fund your own rehabs by borrowing from your retirement account. While there are limits to how much you can borrow, if you’re a part-time investor and only do a limited number of deals per year, a 401k loan is an affordable and great alternative to bankroll your rehabs.
401k Loans Are Not Distributions
Let’s be very clear about this. When I’m talking about borrowing against your retirement account, this is completely different than withdrawing money out of it.
Employees that are under the age of 59 1/2 years old who take a distribution will have to pay a costly 10% early withdrawal penalty in addition to the income taxes that will be due. I do not recommend this.
By contrast, when borrowing from your 401k you are taking out a loan from yourself. This is not considered a withdrawal. Therefore, you do not incur a 10% penalty and you don’t pay income taxes on it. Though you will have to pay yourself back with interest.
I Have a Company-Sponsored 401k, So Can I Borrow Against It?
First of all, not every 401k plan allows you to take a loan out against it. Talk to your HR department and learn about the various options available. Even if your retirement account is with an investment company that allows you to borrow, your specific employer-sponsored plan may have some additional rules that may not allow loans.
Even if you learn that your retirement account does not allow loans, it doesn’t mean you’re out of luck. It may just mean that your 401k with the investment carrier that you’ve selected doesn’t allow it.
For instance, with my company, we have the option to invest with a handful of companies such as Fidelity, Vanguard, TIAA, Prudential, etc. I have been with Vanguard for years and while Vanguard allows 401k loans, my company sponsored retirement plan with Vanguard does not allow it. After speaking with my Benefits staff within HR, I learned that out of all my company sponsored investment carriers, only TIAA will allow loans to be taken out of your retirement.
So what am I now doing? I’m transferring my total balance from Vanguard over to TIAA so that I can now borrow against it.
General Provisions of a 401k Loan
Taking out a loan from your 401k or 403b comes with some caveats. Check with your retirement plan as all plans have slightly different provisions. Here’s a general run through of what to expect.
- Max loan amount: Typically 50% of your retirement balance up to $50,000
- Max outstanding loans: varies
- Some only allow 2, while others allow as many until your outstanding loan amount reaches the lesser of 50% of your balance or $50,000.
- Amortized up to 5 years for general purpose loan or up to 10 or 15 years to purchase a primary residence
- Depending on your plan, the loan may become due upon 90 days of leaving your employer
- Interest: varies
- Typically the interest payment is slightly higher than the interest your account will earn. For example, with TIAA my loan payment will at 4% whereas 3% will go back towards growing my principal. Therefore, my loan is really like a 1% interest loan.
- Application and maintenance fees may apply
- Prepayment penalties: I haven’t seen any, but some may have them.
Ultimately, the rules will depend on your employer-sponsored plan so be sure to check with them. For example, with my company’s TIAA account, I am allowed to borrow only up to 45% instead of 50% of my retirement account up to a maximum of $50,000.
Also, any loan I take out with my company sponsored TIAA account will not become due if I decide to leave my employer. This is a big plus.
Some Additional Considerations
There are some aspects to consider if you’re going to pursue borrowing from your 401k. Some of these will depend on the rules set by your employer-sponsored plan.
- For the duration of your loan, your principal is no longer tied to the stock market. This can be both good or bad. A typical financial adviser may view this as a negative since many feel that investing in the stock market is the best and only strategy for building your retirement. If you borrow during a rising market, you can miss out on some large gains. However, the opposite is true too. If you had borrowed before the 2008 crash, you’d have maintained your value and bought back into the market at discount prices.
- Loan payments (plus interest) are made with after tax dollars. Generally, the retirement account that you borrowed from are pre-tax dollars, but you’ll be paying your loan back with after tax dollars.
- Depending on your plan, if you leave your employer, your remaining loan balance may become due immediately or within 90 days.
- If you are unable to pay the loan back when it’s due or default on your loan payments, your outstanding balance will be considered a distribution. Meaning, it will be subject to the 10% withdrawal penalty if you’re under 59 1/2 as well as income taxes.
Borrowing from your retirement account allows you to access your retirement funds without incurring penalty fees that are associated with an early withdrawal. I don’t recommend borrowing from your retirement account to fund your next vacation or buy a shiny doo-dad.
A 401k loan is an attractive option to help you do more with your real estate investing. With a typical 5 year repayment at very low interest rates where the majority is paid back to your retirement account, it’s a much cheaper option than borrowing from private and hard money lenders.
Ultimately, the rules for a 401k loan are dictated by your employee-sponsored plan. Be sure to check with your employer to determine whether this option makes sense for your specific situation.
Have you borrowed from your 401k to buy real estate? If so, what was your experience?