He Could Spend 16 Years Saving for His First Home. A $50,000 401(k) Loan Offers a Shortcut, Then Puts His Retirement at Risk

An NPR investigation has revealed that a typical household earning a median income now requires 16 years to accumulate enough savings for a down payment and closing costs on a home. This duration is double what it was in 2019.

Consider a 50-year-old renter who has $500,000 accumulated in a 401(k). If he adheres to this timeline, he would not be able to purchase his first home until he is in his mid-60s, which is close to the age when he might retire.

Delaying homeownership carries its own financial implications. The Case-Shiller national index indicates that home prices have risen by 2.1% over the past year. For a starter home priced at $300,000, such an increase would add approximately $6,300 to the overall cost and raise the down payment by $1,260, thereby extending the timeline for his savings goal.

There is a potential solution for him to borrow $50,000 without incurring immediate tax liabilities. According to the tax code, specifically under 26 U.S.C. § 72(p)(2)(A), the maximum loan amount is limited to either $50,000 or half of his vested balance—whichever is lower. Since half of his $500,000 balance exceeds $50,000, he qualifies for the maximum amount available.

However, it is important to note that individual plan documents may impose stricter conditions than federal law. Some plans may not permit loans at all, while others may not allow extended terms for home purchases.

Typically, IRS regulations require that a 401(k) loan be repaid within five years. However, loans utilized to purchase a primary residence may qualify for an extended repayment period. Payments must be made in substantially equal installments, at least quarterly, with the specific terms determined by the plan.

For instance, if we assume an interest rate of 8% on the loan and a $300,000 mortgage with a 6.5% interest rate over 30 years, under a 10-year repayment schedule, the borrower would pay approximately $22,800 in interest—benefiting his own retirement account. However, he would be repaying the loan with after-tax income and would face taxation on the interest again upon withdrawal in retirement.

In the event of a job loss, he may be required to repay the outstanding loan amount. Failure to do so could result in the loan balance being deducted from his retirement account as a plan loan offset. He could avoid taxes by rolling over that amount into an IRA, but he would need to provide the necessary cash by the due date of his tax return, including any extensions.

If he were to leave his job at age 50, he could face a tax bill of $16,000, assuming the entire $50,000 loan becomes taxable. This amount would consist of $11,000 in federal income tax, based on the 22% tax bracket, plus a $5,000 early withdrawal penalty, not including any applicable state taxes.

However, he could avoid the penalty if he separates from his employer during or after the year he turns 55, thanks to the Rule of 55, which does not apply to IRA withdrawals. Additionally, failing to make loan payments while still employed could trigger a taxable distribution if he does not rectify the default within the allowed timeframe of the plan. Unlike certain offsets after job departure, this type of distribution cannot be rolled into an IRA.

While the opportunity cost of the borrowed funds may appear minimal, with an estimated difference of about $5,200 over ten years based on a 9% annual market return and an 8% loan rate, the more significant financial risk lies in his budget. If he opts to cover the $607 loan payment by reducing his 401(k) contributions by the same amount, he could potentially forfeit about $117,000 over the decade, which is critical during the years when catch-up contributions become increasingly important.

For those with stable incomes, taking out the loan could enable homeownership several years sooner. While the interest paid goes back into his retirement account, it is crucial that the loan payments fit within his budget without sacrificing retirement contributions. Before proceeding with the loan, he should ensure he has a written understanding of the plan’s loan policy, confirm the maximum repayment term for a primary residence, and understand the implications if he leaves his job. If the full loan payment stretches his budget too thin, he may need to consider a smaller mortgage to safeguard his retirement savings.

It is advisable for him to maintain sufficient cash reserves to cover potential tax liabilities. In this scenario, having $16,000 available outside the plan could help cover federal taxes and penalties, but to completely avoid the tax implications through a rollover, he would need enough funds to replace the outstanding loan balance.