The 401 (k) is a company-sponsored retirement savings plan for employees in the United States. It is not mandatory and not all employers offer them. If you do have a 401 (k), you may, depending on the circumstances, have the option of borrowing money from it. It is not a decision to be taken lightly however, as there are many conditions that must be fulfilled, and even if you do it right, you should also consider the ramifications for your future as you are dipping into money that were intended to be kept invested in order to grow for your retirement.
What is a 401 (k)?
The 401 (k) is a company-sponsored retirement savings plan for employees in the United States. It is not mandatory and not all employers offer this. Also, it is not mandatory for the employee – you need to opt in if you want to save in a 401 (k).
If you sign up for a 401 (k) plan, a percentage of every pay check you receive from the employer will go directly into your 401 (k) retirement savings account. The employer may then match all or part of that amount.
Saving for retirement in a 401 (k) can be advantageous from a tax perspective.
Why is it called 401 (k)?
It is named after a section of the U.S. Internal Revenue Code (IRC).
What happens to the money in the savings account?
The employee gets to chose among various approved investment options. It is very common for 401 (k) savings to be invested in mutual funds.
Borrowing from your 401 (k)
In the United States, it is permitted for an employer to allow their employee to take out a loan against their 401 (k).
Borrowing money from your 401 (k) does not impact your net debt-to-income ratio, since you are essentially borrowing from yourself.
It is important to adhere to the rules for a 401 (k) loan. Among other things, it must be repaid quickly enough, otherwise it will be considered an early withdrawal instead of a loan, and an early withdrawal comes with a 10% penalty.
Borrowing from a 401 (k) to purchase a primary residence
We all need to live somewhere, and the law makers have therefore made it easier to borrow from your 401 (k) if you are doing it to purchase a primary residence. If you fulfil the requirements, you can repay the loan over a longer period of time than what is normally required for a 401 (k) loan, i.e. slower than within 5 years.
As mentioned above, borrowing from your 401 (k) will not impact your true income-to-debt ratio. This can be important if you also need to qualify for a standard mortgage loan to be able to buy the home.
Important: Most types of home mortgage loans will qualify you for tax deductions for the interest payments. This will not happen for your 401 (k) loan and that is important to take into account when you calculate the pros and cons of using a 401 (k) loan.
Special Covid19 rules for 401 (k) retirement savings plans
Before you make any decisions about borrowing money from your 401 (k), check up on the CARES Act to see if any of those provisions would still impact your situation. The CARES Act was launched as a form of Covid19 pandemic relief. Among other things, it includes relaxed rules for how much money an employee can borrow from their 401 (k) savings. For more detailed information, visit the irs.gov.