Using a 401(k) to pay off a mortgage might seem like a great idea; however, whether it will work or not depends on how much you have in the 401(k), and whether it will benefit you depends on interest rates and other factors. If you do want to take out a 401(k) loan, it's as simple as completing forms with your 401(k) plan's administrator and then setting up your repayment.
Borrowing from your 401(k) to pay down a mortgage is a simple process; your particular circumstances will determine whether it's a good idea. You can't borrow more than $50,000 from a 401(k) in any event.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement account, named after Section 401 of the United States Tax Code. You can only get a 401(k) through work; you cannot create one on your own. Most 401(k) plans work in basically the same way: Your employer takes a percentage of each paycheck, before taxes, and deposits it into your 401(k) investment account, where it accrues interest over the years. When you retire, you can take money out of the account to pay for living expenses, and you pay taxes on it, just as if it were earnings from a job.
Tax Deferral Benefits of a 401(k)
Because the money for funding your 401(k) is taken from your paycheck before taxes, it allows you to reduce your taxable income now and pay the taxes later. This tax deferral is a benefit because it allows your contributions to accrue interest and grow tax-free. Because of this, the IRS puts strict limits upon when and how you can take money from your 401(k).
Withdrawing From a 401(k) Plan
Because your 401(k) is intended for retirement, and because you're receiving the tax-deferral benefits, you generally cannot withdraw funds from your 401(k) before you reach the age of 59 1/2. If you're 59 1/2 or older, you can withdraw money from your 401(k) without penalty (although you will have to pay taxes on the withdrawals since you didn't pay taxes on the income you used to fund the account).
Penalty for Early 401(k) Withdrawals
If you withdraw funds before you turn 59 1/2, you'll have to pay a 10 percent penalty in addition to the income tax. You may avoid this penalty if you leave work during or after the year you turn 55 and withdraw the funds then, or if you're totally and permanently disabled. However, the penalty is also not assessed if you take out a 401(k) loan.
How Do 401(k) Loans Work?
A 401(k) loan is a loan you take from your 401(k) account, which you pay back with interest. Since the money in the account belongs to you, you're essentially borrowing money from yourself, and the interest you pay back goes into your account. Your repayments will come back out of your paycheck. The money you take from a 401(k) loan is not considered taxable income, and so it isn't taxed, and it isn't penalized as an early withdrawal.
How Much Can You Borrow From Your 401(k)?
You can only borrow up to 50 percent of your 401(k) account's total vested value, and no more than $50,000. This means that if you have a vested balance of $400,000 in your 401(k), you can still only borrow $50,000 or less pursuant to IRS rules. There is an exception in some plans: If your account balance is $20,000 or less, you can borrow up to $10,000, even if it's more than half. However, not all plans will permit you to do this.
How Long Do You Have to Pay Back a 401(k) Loan?
Most 401(k) plans require that you pay loans back within five years. If you leave your employer, however, you must pay the loan back within 60 to 90 days, depending on your plan. If you don't pay the loan back within the required time, the remaining balance of the loan will be treated as an early withdrawal, and you'll have to pay income taxes plus the 10 percent penalty, if applicable.
Can You Borrow From a 401(k) to Pay Off a Mortgage?
Paying off a mortgage is one reason you might borrow from a 401(k). If you have a low mortgage balance and a substantial 401(k) balance, you might be able to pay the mortgage off, but because of the limit on how much you can borrow, paying the mortgage in full is unlikely. For example, if you have a $150,000 mortgage balance and you have $200,000 fully vested in your 401(k), you can only borrow $50,000, and so you'll still have $100,000 left to pay on your mortgage.
Keep in mind that if you pay off a mortgage with a 401(k) after retirement, you can do so without taking out a loan and without paying the 10 percent tax penalty, as long as you're 59 1/2 or older.
Should You Borrow from a 401(k) to Pay Off Your House?
Whether you should borrow from a 401(k) to pay off a house depends upon a number of factors, including how close to retirement you are, how much your mortgage balance is, how much you have in your 401(k) and the terms of your 401(k) plan.
If your mortgage interest rate is 4 percent but the interest rate for repaying the 401(k) loan is 3 percent, it might save you money; however, if your plan doesn't allow you to continue making contributions to your 401(k) while you have a loan in repayment, you'll have up to five years where you're not making contributions to your retirement except for the 3 percent loan repayment interest. Plus, if you leave your employer early, you have to pay the loan back within two to three months, and if you don't, you are assessed income taxes and the penalty. The best way to determine whether such a loan is the right decision is to speak to an accountant or a tax attorney about your particular situation.
Setting up a 401(k) Loan
How to take out a 401(k) loan will depend on your plan and the funds in which your account is invested. Generally, it's a fairly simple process. You should look at your plan description documents provided by your human resources department or your plan provider (Fidelity, Ascensus, etc.) to find out what to fill out, how much you can borrow and what repayment terms are available. Determine how much you want to borrow and complete the required paperwork; some plans will allow you to request a 401(k) loan online, while others may require paper documents.
Repaying a 401(k) Loan
Once you receive the money, either via direct deposit or check, your employer will start deducting the repayments from your paycheck every pay period. The repayment amount will depend on how much is required to pay the loan back in full, with interest, over the set time period required by your plan. The repayments will include the principal you borrowed plus interest; interest is determined by your plan's rules. The repayment funds will go back into your retirement account, including the interest.
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D. She has written finance and tax articles for Pocketsense and eHow.