We ask a CPA for advice
Should You Use a 401k Loan to Pay for a Bathroom Remodel?
by Paige Estigarribia
How a 401k Loan Affects Future Wealth
What You Need to Know About Managing Debt as You Near Retirement
Should You Consider a 401k Loan to Repay a Personal Loan
Not too long ago, one of our readers reached out to us and asked about paying for a home master bathroom remodel. Her home was over 30 years old, and she'd never done any kind of major renovations. She desperately needed to redo the bathroom floors and the shower, and she also wanted to replace the countertops. When the estimates started coming in, she began to wonder how to pay for the bathroom remodel.
She'd asked us about whether she should take out a 401k loan to cover some of these home remodels. We posed her question to a CPA and creator of DistilledDollar.com. Here are his tips on paying for home repairs with a 401k loan:
Q: What are the main considerations someone should think about when deciding whether to use a 401k loan for home repairs?
DistilledDollar: If you don't have a strong knowledge of 401k basics and how a loan can affect future wealth, make sure you understand the full implications of taking out the loan. I'll walk through the potential value you can access and what the loan terms will look like, including repayment.
Unlike a personal loan or a mortgage, a 401k is taken against the value of your own assets located within your 401k.
The amount you can withdraw might depend on your individual plan, but the general guideline is that the amount of the loan can be no greater than either:
A) $50,000, or
B) 50% of the value of your 401k
As an example, if your 401k has a balance of $80,000, you can take out $40,000 at most as a loan. If your balance is greater than $100,000, then you are limited to a $50,000 loan.
Repayment terms for a 401k loan involve at least a quarterly payment and the term will typically be for five years. Again, each employer may have differing periods, so always check to see how their options might differ.
Q: What are some situations where using a 401k loan for home repairs would be a good option?
DistilledDollar: You may have heard someone tout the benefit to borrowing from yourself is that your interest payments go directly towards your savings, instead of ending up with a financial institution. This is true, but there are many more factors to consider when determining if a 401k loan is right for you.
There are a few factors that should come together to make a 401k loan a great option for home repairs.
The first is if the repairs are necessary and urgent. Second, 401k loans are often at a lower interest rate than you may find elsewhere, so if you're unable to obtain financing at a lower rate, than a 401k loan becomes a more viable option.
Lastly, you should have a consistent streak of being able to fund your current 401k. With the loan being taken out, you will want to repay the loan in time to meet your current retirement goals. As a part of this, your employer might elect to not make any matching contributions until you have repaid the 401k loan or if you have missed any payments.
Q: When would you recommend not using a 401k loan for home repairs?
DistilledDollar: If you plan on leaving your employer soon, then taking out a 401k loan will not help you. Once you are either terminated from your employer or leave voluntarily, you must repay the remaining balance of the loan within 30 to 60 days, depending on your employer.
Another scenario where I would not recommend a 401k loan is if you are nearing the age of 59 1/2. The amount of time you have to repay your loan is diminished. If you take out a 401k loan and are unable to repay by 59 1/2, then you will need to pay regular income taxes in addition to the 10% early withdrawal penalty.
Q: Are there unexpected consequences of using a 401k loan for home repairs?
DistilledDollar: When taking out a 401k loan, many people need to factor in what payments they will need to reorganize to meet the new obligation.
While the loan does offer a quick amount of cash, there are often second and third level ramifications to adding a large monthly debt payment to your budget. Please be sure to factor in this additional liability into your budget to see if it makes sense to you.
Q: What do some people often forget about when they decide to use a 401k loan for home repairs?
DistilledDollar: Most people understand a loan is tax free, but if you leave or are terminated by your employer and fail to repay the loan in the 30- to 60-day window offered by your employer's plan, then the resulting balance will be seen as a taxable distribution. If you end up taking a 401k loan, be prepared for this event.
If you are unable to repay the balance, you are forgoing the 401k contributions you could have made and suffering from the resulting tax consequences. This ends up being a lose-lose scenario.
Overall, when considering a 401k loan, it is best to confirm what the loan terms will be with your employer's plan. Be sure to factor in your current loan obligations such as your mortgage and consider how your current retirement plan will be impacted by taking out a 401k loan.
Reviewed August 2017
Matt is a Chicago based CPA helping people to extract the vital aspects of personal finance as they pursue financial independence. Matt's site DistilledDollar.com was created as a way to connect with others while sharing in the stumbles and triumphs of building wealth.
Paige Estigarribia is a writer for The Dollar Stretcher who enjoys writing about food, frugal living, and money-saving tips. Visit Paige on Google+.
Take the Next Step:
- Find more on managing your 401k by visiting the Dollar Stretcher Library.
- Don't miss these 10 tips for remodeling a bathroom on a budget.
- Have you considered a HELOC for financing your remodel? See if a HELOC is a smart option for financing this project.
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