Though you borrow most of the money you need to buy a house to pay for a mortgage, the down payment and closing costs can hamper your ability to transition from renting to owning. Whether you're close to avoiding having to pay for private mortgage insurance or just scraping up enough for a low down payment mortgage, a 401(k) loan might provide a little extra to help you become a homeowner.
No Taxes for Borrowing
Taking out a loan from your 401(k) plan for a first home isn't a taxable event. You only have to pay taxes when you actually take a distribution from the 401(k) plan, and since you're going to repay the loan, it's not counted as a distribution. As long as you repay the loan according to the terms of the loan, you won't owe any taxes on it.
Usually, you have to repay the loan, with interest, within five years for a permissible 401(k) plan loan. However, if you're using it to purchase your main home, the five-year repayment period can be lengthened, if your 401(k) plan allows. For example, according to Consumer Reports, some plans allow you to take 10 years to repay 401(k) plans used for homes. You do have to pay interest on the loan, but it goes right back into your 401(k) plan, which means you're basically paying yourself.
Consequences of Default
If you can't pay back the loan from the 401(k) plan, then you will have tax issues. First, the amount you still owe at the time you default is treated as a distribution. Second, if you're not at least 59 1/2, you will owe an extra 10 percent tax penalty because you loan default is considered an early withdrawal. No exception to the penalty exists for first-time home buyers who can't repay a 401(k) loan. Worse, if you lose your job, your loan will become due in full immediately.
No Tax Break for Repayment
Even though most employers will allow you to have repayments deducted directly out of your paychecks, you can't double dip by excluding those payments from your taxable income. If you did, you'd essentially be getting two tax deductions for the same contributions because you aren't taxed when you take the money out of the 401(k) plan with a loan. Instead, you won't get a tax break for repaying the loan, but at least you're paying yourself interest rather than a bank.
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