The Retired Investor: Does It Make Sense to Borrow From Your 401(k) to Buy a House?

Younger generations cannot afford to buy a home. They cannot even make the down payments necessary to take out a mortgage. Borrowing the down payment from your 401(k) might make sense, especially if the Trump administration helps out.

 

Last week, the president's director of the National Economic Council, Kevin Hassett, said the administration was finalizing a plan for some 401(k) funds to go toward home down payments. He said it would be part of a series of White House initiatives on housing affordability.

 

"I'm not a huge fan," said the boss. Trump said, "One of the reasons I don't like it is that their 401(k)s are doing so well." 

 

And that is true. The problem is that after several years of exorbitant gains, the potential for a large sell-off is growing.

 

Readers should know you can already use your 401(k) for a home down payment, either through a withdrawal or a loan, though both options have drawbacks. Under existing hardship withdrawal rules, buying a principal residence is one of the permitted reasons.

 

The problem is that you owe income tax on the withdrawal, which could also move you into a higher tax bracket. If you are younger than 59 1/2 years old, you owe an additional 10 percent penalty on the money you withdraw. You also lose out on years of future tax-free earnings on the money you withdrew.

 

However, you also have the option to borrow the money for a house from your 401(k) to the tune of $50,000 or half the value of your account, whichever is less. But there are several drawbacks. For one, you are required to repay the loan within five years and report it to the bank if you are applying for a mortgage.

 

In addition, if you leave your job, you must repay the loan by the due date of your federal income tax return, or the loan will be considered a withdrawal. That would trigger income taxes and possibly another 10 percent early withdrawal penalty if you are under 59 1/2 years old. Worse, depending on your plan, you may not be able to contribute to your 401(k) until you pay off the loan.

 

You are charged interest on the money you borrow, usually two points over the prime rate. The good news is that you are borrowing from yourself and earning a little on the funds you withdraw. The downside, whether borrowing or withdrawing, is that you miss out on potential investment growth for retirement savings. That final negative is what the president doesn't like.

 

How could the government help reduce the negatives? An increase in the borrowing or withdrawal limit might help. They could also do away with the 10 percent tax penalty for those under 59 1/2 if you were to withdraw rather than borrow funds or even make the withdrawal tax-free if it was earmarked for the purchase of a home.

 

For borrowers, the IRS could also extend the repayment period from 5 years to 10 years or longer. The rules could also change for those who have left their job. Rather than forcing repayment or treating it as a withdrawal, the rules could be changed. For example, as long as you obtained another job before the end of the tax year, the borrowing rules would remain the same and not trigger the exiting tax consequences.

 

The issue I am sure the administration is wrestling with is that withdrawing the money from your tax-deferred savings account to buy a house puts those funds on a different track. In an era when younger generations and many politicians are convinced there will be no social safety net like Social Security, saving for retirement becomes critical.

 

Making withdrawals or borrowing for a home from tax-deferred savings makes it easier to divert that money from its original purpose: compounding growth for your retirement through investing in the stock and bond markets. In exchange, you could say you are diverting some of your retirement money into real estate.

 

Given the growing dissatisfaction with their lot in life, younger generations might prefer the ability to own a home, start a family, and get out from under their parent's spare bedrooms or basements, worth the cost of a little less in retirement savings.

 

That may not be a bad thing. Over half of Americans' wealth today is attributed to their real estate holdings, namely their home. Diversifying one's investments is rarely a bad idea. If the rules were relaxed, and let's say two million Americans borrowed $100,000 each for a home, those transactions would have a substantial impact on U.S. economic growth as well. In turn, financial markets would rise, and the remaining funds in an existing 401(k) portfolio of stocks and bonds would also gain.