Borrowing Against 401(k)
The employers can make matching or non-elective contributions to the 401(k) plan on behalf of employees, and may choose to add a profit-sharing feature to the plan. Since this is a qualified plan, the employers are allowed to deduct their contribution for each participant before calculating taxes. Contributions and earnings accrue on a tax-deferred basis until they are withdrawn. To know more about 401(k) contribution limits, one may refer to the article on 401K Contribution Limits.
Distribution of elective deferrals before the age of 59½ will result in the borrower incurring a penalty of 10 percent additional tax, unless the employee dies, becomes disabled, or faces hardships. Early distributions are also allowed if the plan is terminated.
Borrowing Against 401(k)
The plan document will specify if one is permitted to borrow against 401(k). Most 401(k) plans allow the borrower to avail a loan that is equal to 50 percent of the vested account balance. The maximum amount of loan that can be procured cannot exceed $50,000. Moreover, it has to be repaid within a period of 5 years, unless the loan was for the sake of buying the borrower’s primary residence, in which case, the repayment period is usually 10 to 30 years.
Borrowing against 401(k) for Down Payment on a House
People who need money for making a down payment on a house may consider borrowing against 401(k), for home purchases qualify for a repayment period of 10 to 30 years. The repayment of the loan is a fairly simple procedure since the amount is deducted by the company from the employee’s paycheck. In fact, borrowing against 401(k) is akin to borrowing from oneself at a low rate of interest without any credit checks. The interest is usually a few points above the prime lending rate.
Although a loan against 401(k) seems ideal, there are a few drawbacks. People end up losing interest on the amount that is borrowed, since the borrowed sum does not appreciate on account of capital gains, interest, and dividend income. The money that is borrowed from 401(k) is repaid with after-tax dollars. Hence, one is unable to benefit from the tax-sheltered component of the plan. The loan may become a premature distribution if the employee is unable to repay the borrowed sum. Hence, borrowing against 401(k), for a house, should be considered only if one has exhausted all other avenues of procuring loans.
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