How Do I Borrow From My 401K?

I have the opportunity to buy some excellent real estate…for cheap $$. However, I don’t have the cash to do so. I do have sufficient funds in a self-directed 401K-can I set up a real estate investment trust, and fund it from the 401K-can this be done?

It looks like you are asking two different things. One is to borrow money from your 401k – just call up the 401k administrator and ask to borrow some money. The catch is that you pay it back with after tax money. There are also various IRS restrictions on amount you can borrow and repayment period, but your 401k administrator will let you know all that.

The second thing you are asking is to fund an investment within the 401k. If your administrator can accomplish that for you, it could work out better, but again, the only one who can tell you how to do it (or if you even can do it) is your 401k administrator.

Additionally, keep in mind that, generally, if you miss even one loan payment, the entire loan defaults. At the company I’m familiar with, this means that A.) the remaining loan balance is considered taxable (with a 10% penalty if you’re under the age of 59 1/2), but B.) you still have to pay it back because, without a qualifying event, the funds can’t be taken from your 401(k).

Also, usually the funds you use to secure the loan are put into an account earning a fixed, low rate of interest; you can’t put it in the market or anything.

It is legal for you to buy real estate investments via your 401k or other retirement account. However, you may not buy it for a related party or enjoy personal benefit (no living in it, vacationing in it, taking rental income yourself, letting kids use it, etc.).

And, just because it’s legal doesn’t mean that your administrator’s rules have to permit it.

As for the loan… your administrator will also have their own rules. But I say just don’t do it.

I’d be very surprised if you both have to pay it back, AND take the penalty. That basically boils down to your paying a penalty on money you don’t even get to keep.

You can certainly take money from a 401(k) without a qualifying event - well, the administrator might not let you, but people cash out their plans when they change jobs all the time. Of course, they get hit with the tax bill including the penalty which is why it’s a bad idea.

In general (IMHO) a 401(k) loan is a bad idea because of all those risks. Even if you’re making the payments on time you’re messing with your retirement. AND, if you lose a job or simply change jobs, you have to pay the whole thing back RIGHT THEN.

Loans from a 401(k) are not a bad idea and since the nominal interest you pay is paid to yourself, it can be a much better option than going to the bank, assuming the plan administrator allows them. The caveat is that the principal from your retirement account is not appreciating beyond the nominal interest, but over the last couple years I’m sure many would have been happy with a 4-6% annual return.

Now then, if you default and don’t pay back the loan then you are hit with the additional income and 10% penalty. If you default and pay back the loan then you are not with any additional income or penalty. The rules and regulations will be spelled out in your particular plan documents.

And SmartAlecCat, of course you have to pay it back with after tax money. But you aren’t hit with a 1099 for the loan so it’s ‘tax-free’ income unless you default, and you can’t write off principal repayments on your taxes anyway.

I would just add another danger of a 401k loan. If you get fired from your job that the 401k is related too you can be required to pay back the entire loan amount often within a month or two or face default.

Taking out a loan is between you and your employer or the 401k administrator. It is a LOAN and you do not owe penalties on it. You are obligated to pay it back.

Withdrawing money from your 401k means you are under to obligation to pay it back. You can keep it if you want. However, come April 15, the government will want their cut. You will pay taxes on your withdrawal as it was deposited pretax into the 401k. In addition, you will owe a federal penalty of 10% if you are not 59.5. You may also owe state penalties, at least in California, 2.5% IIRC.

If you wish to do the former, take out a loan, read the fine print. If you wish to do the latter, withdraw money, then I would strongly counsel against it. If you feel you can pay back your withdrawal before the end of the year, then it may be worth it, but even then it could be risky,

Yes, it is a LOAN.

HOWEVER - if you change jobs, the entire loan becomes due at that time. If you are unable to pay back the outstanding balance at that time, then it gets converted to a withdrawal. With all the penalties and taxes that result from a withdrawal.

And as another poster noted, it might even get treated as a withdrawal if you are late on a payment.

401(k) loans should be approached very, very cautiously.

Suppose I were to move my 401K fund to a local bank? Then, could I pledge the 401K account as collateral for a mortgage loan? Would that work?

I doubt it but I can’t find anything specific. Some unofficial answers:

http://answers.yahoo.com/question/index?qid=20070504182727AAwFZf1

By “move to a bank” - I suspect if you’re an active employee, you cannot do that but I could be wrong; perhaps your plan is an unusual one.

If you’re no longer with the company but your money is still in their plan, then such a move would be essentially converting it to an IRA which is of course a legitimate thing to do. However, loans against IRA accounts are explicitly prohibited.


http://www.irs.gov/retirement/article/0,,id=162415,00.html (see #2).

The federal government has very few requirements for loans, e.g. max 5 year payment term. It is my understanding that while some employers may require stricter terms as you mention, it is not a federal requirement. If you can find something suggesting that ALL employers make it a withdrawal immediately upon termination, then I would consider it inherent of loans. Yes you should approach them cautiously, which is why I suggest reading all of your employer’s terms.

Yep.

I got a referral for a new client today. They took a 401k loan two years ago to cover medical costs. They lost their job last year and so the loan became a withdrawal. The kicker is two-fold

  1. all that tax and penalty is due now, when they’ve been out of work for months
  2. you can avoid the 10% penalty on withdrawals for medical expenses… but the effective withdrawal is in the year AFTER the medical expenses. So there’s no way to be exempted from the penalty.

I tell people to look into bankruptcy before they take a loan against a 401k. At least bankruptcy leaves your retirement intact.

Huh.

I “always knew” that a loan became due upon separation but since you raise that question, I thought I’d google it.

http://www.401kplanshelp.com/withdrawals-and-loans-from-401k/

http://www.ocregister.com/articles/loan-retirement-borrowing-2525409-people-loans (financial columnist mentions the repayment)

http://www.uncommon-cents.net/2008/05/06/stupid-money-tricks-401k-loans/

These all say that the loan becomes due within a short time after leaving a job, but so far, I can’t find a cite at the IRS website.

So, perhaps it’s not legally mandated that the loan is due upon termination - but perhaps it is. In any case, one would need to read the plan docs VERY carefully before taking such a loan, and have a plan in place for what to do if this happens.

Okay. I’m familiar with 403(b)/501©3 plans more than 401(k)s, but. . .yes. You’re taxed on the amount of the default effective the year of the default (and any age-related penalties will apply), and you still have to pay the loan back. It continues accruing interest until you do. If you pay back the loan, when you do cash out the account, you’re credited the cost basis for what you paid taxes on, so you’re not double-taxed. You just pay it now instead of later.

If the loan hasn’t been paid back at the time you close the account, it’s deducted from the total account value (assuming, of course, you have that aforementioned qualifying event). You get whatever’s left after appropriate taxes are deducted. It isn’t deducted until that time. With the contracts that I’ve seen, closing the account isn’t required upon termination of employment–this is not, however, an uncommon requirement on 401(k)s. If a plan has that provision, then the loan would be due upon termination of employment. But that isn’t an IRS requirement. It is most certainly not the case on 403(b)s, which is the majority of what I’ve dealt with.

Whether closing the account is required upon severance of employment is up to the plan administrator.

Switching jobs is considered a qualifying event. Qualifying events are reaching the age of 59 1/2, severance of employment, and disability. Switching jobs is considered severance of employment with the original employer. However, severance of employment does not waive the early withdrawal penalty from the IRS, unless it occurs after the individual reaches the age of 55. That’s the actual date of severance–if the severance occurs at the age of 54, you have to wait until 59 1/2 to take it out without penalty, unless you’re considered disabled.

There are circumstances where you might be able to take out money as a withdrawal for financial hardship without another qualifying event. At the company I’m familiar with (as in, I’ve worked with them for over five years in that area), it requires that no loan be available, and that certain other avenues be certified by the contract owner as having been exhausted (personal loans, liquidation of non-retirement assets such as bank accounts). Proof is not required, but it’s stated on the paperwork that it may need to be provided to the IRS in the case of an audit or something of that nature. The amount that can be taken is also limited, so the account usually can’t be liquidated. Also, it’s still considered an early withdrawal, and is thus subject to the 10% tax penalty.