Borrow against your 401k funds when buying a house- Good or Bad?

11/20/12
Dear Uncle Sam,
Is it better to borrow against your 401k funds when buying a house rather than a regular mortgage?  If so, why? Better rates?  Is there a tax benefit? And just in case you end up defaulting for some reason, are the consequences better or worse from a tax perspective?
Thank you for your help!
Rae from Brooklyn
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Dear 401-Rae,

     It is uncommon, ill-advised and potentially impossible to borrow against your 401k in lieu of a mortgage. Also, you are right to bring up default- as defaulting against a retirement plan loan will have major negative consequences in most cases. For the purpose of this response, I am going to assume the potential borrower is a good deal younger than 59 1/2, income-stable, and eligible for a normal mortgage (on what will be their primary residence). Your question can segue into numerous other areas of finance and tax, but we'll keep it on point.
     Uncommon: First off, there is the issue of a tax benefit. Although recent "fiscal cliff" talks approach the idea of limiting itemized deductions, including the deduction for qualified mortgage interest, there is ZERO tax benefit for the interest paid on a 401 loan. Whether you borrow the funds for medical expenses, to pay off escalating credit card debt, or to put down cash on a home purchase, the loan interest is considered non-deductible for tax purposes. Many folks are eligible to deduct 100% of their qualified mortgage interest, and that is not likely to drastically change. I am confident in stating that opting for a 401k loan in (partial) lieu of a mortgage is very rare. Although not as much the case, it is also quite rare for a taxpayer to pay mortgage interest, especially as a new homeowner in the expensive NY area, and not realize any tax benefit from the mortgage interest deduction.
     Ill-Advised: Secondly, there is the issue of overall monetary savings. Since mortgage interest rates are still quite low, it is even more difficult for a 401K loan to be a better choice. Not only is the interest paid not tax deductible, the principal repayments are not tax-deferred and the loan amount will not compound interest and/or dividends. Even if you continue the same pre-tax contribution percentage, your retirement plan will not grow at the same rate it would if you did not take out the loan. The market is still rocky, as Uncle Sam is very aware, but the further a borrower is from retirement age, the more this loan could negatively impact his/ her future nest egg. Your Uncle Sam believes in government programs, but wants all his nieces and nephews to be responsible with their private retirement accounts. If you default on a 401k loan, the unpaid amount is considered a taxable distribution of income and also generally subject to an additional 10% tax penalty for early withdrawal. If you think the 10% penalty is a real slap, also consider that a higher Adjusted Gross Income will likely increase your marginal tax rate and even make you ineligible for some deductions and credits that you might otherwise have benefited from. The worst case scenario of a defaulted mortgage is that the unpaid debt would be included in a taxpayers' income (no 10% penalty). On account of what is deemed "discharge of qualified principal residence indebtedness", however, many taxpayers are saved from even paying income tax on a default. This topic is for another time and place, but I will stress that it cannot be worse than 401k default (and is likely better).
     Potentially Impossible: 401k plans are not required to allow participants to borrow money. The IRS only states that they may, and sets the limit at $50,000 or 50% of the vested plan assets, whichever is less. If the plan does indeed allow for borrowing, it may nevertheless have stipulations as to who can, and for what reasons. As the plan administrator has such discretion with regards to its participants' loans and distributions, contacting them would be necessary if you need to fully weigh the positives and negatives of each loan option.
     Being a homeowner has many tax advantages. If you need to borrow a few thousand dollars to help meet the minimum down payment, that is reasonable. After all, you won't get a mortgage loan to begin with if you don't have any money to put down! Ideally, a future homeowner has the foresight to amass this deposit in advance of a purchase, but opportunity can knock at unexpected times. We've all been there. Just realize that putting more down than is required, and taking that money from your 401k, is not the safest or smartest route. That is, of course, my humble opinion.

Thank you for being an informed taxpayer,
Your Uncle Sam

For the purpose of this web page, Uncle Sam is the pseudonym of Christina Sharkey, Enrolled Agent.
CIRCULAR 230 DISCLOSURE : IRS Regulations require Sharkey Tax LLC to notify you that this communication is not intended to be used, and cannot be used, by you as the taxpayer, for the purpose of avoiding penalties that the IRS might impose on you.