NEW YORK (CNNfn) - You and your spouse are thinking about buying a first-time home -- and to come up with the cash for a down payment you plan on dipping into your retirement account, which is growing at a nice clip. But is it wise to pull from your future savings to fund a project you'll enjoy now?|
If no other alternatives exist, borrowing from your 401(k) plan can be a good choice. How else could you afford that new home?
But personal finance experts warn that you should be aware of many rules associated with taking a loan from your employer-sponsored plan.
What are the rules?
First, does your company allow you to borrow from your 401(k) plan and how long do you have to pay the money back?
Some employers stipulate that you borrow only for "hardship" loans, such as funding a first-time home, educational needs for your children, preventing eviction and medical needs, says certified financial planner Dee Lee. You may not be allowed to borrow from your 401(k) to buy a Harley-Davidson motorcycle or to fund that two-week vacation in Barbados.
Most plans allow you to borrow as much as half your account balance with a cap of $50,000. Generally, you have five years to pay the loan back, and up to 15 years if it's for buying a home.
The interest you pay, usually the prime rate plus one or two points (so about 9.75% to 10.75%), goes back into your own account through automatic payroll deductions from your salary. However, it's not pretax dollars like your regular contributions.
The downside of borrowing
Compounding. The benefit of compounding is lost when you borrow a chunk of money from your retirement plan, says Martha Goodman, director of client services at the Personal Education Finance Company.
"The money is out of the plan so it's not earning anything," she said.
Staying put. Be sure you're going to stay at your job awhile before taking out a loan on your 401(k). Many employer-sponsored plans stipulate that the loan be paid back within 30 to 60 days after you quit the company.
"The spouse with the more stable job should consider taking out the loan," Lee said.
Early distributions. If you borrow $10,000 from your 401(k) plan and can't pay it back because you were laid off or just can't afford it, then it's considered a premature distribution, or withdrawal. That means you'll owe income tax on the money, plus a penalty if you're younger than 59-1/2 years old.
Now if you decide to dip into your IRA, there is a different set of rules.
Unlike an employer-sponsored plan like a 401(k), an IRA doesn't allow you to borrow, but you may take out up to $10,000 during your lifetime. You won't pay a penalty on that amount, however you will pay taxes.
"People tend to look at [the IRA] as 'I have that money in that account,'" Lee says. "They forget that it's for when you're over 60."
Experts agree that you should consider all of your options before dipping into your retirement plan. So aside from taking out a home-equity loan, bear in mind the possibility that:
-- A family member could give you a gift towards a down payment on your first home.
-- A family member could make the loan to you and you could repay him or her on a scheduled basis.
"I wouldn't necessarily consider [taking a loan from your 401(k)] a last resort, but you must consider it very carefully," Goodman said.
"You may end up with a house today,
but you may not meet your retirement goals in the future."
-- Martha Goodman of the Personal Education Finance Company
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So if you think buying a home is a good long-term investment, go ahead and borrow from your retirement account, says Lewis Altfest, a family finance expert in New York.
"If there's no other money," it's a viable alternative to borrow, he said.
Again, he stresses that you lose the benefit of the compounding on your retirement account, but instead, you get compounding on your house. Homes typically increase in value over time so the trade-off is weighing your retirement account with the value of your house.
"It's a lifestyle decision, look at the bottom line," Lee said.