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- Borrowing from tax-advantaged accounts may end up costing you more than your original contributions.
- If you lose your job or move on to a different opportunity, you’ll have to pay your entire loan balance back by the due date of your federal tax return.
- You can borrow up to 50 percent — or up to $50,000 — of your 401(k) for home improvements.
Between market fluctuations, inflation and the interest rate hikes, funding your next home improvement project can seem like an impossible task. As a result, it may seem enticing to draw from the money you’ve already saved up; more specifically, your retirement savings.
While there are more immediate benefits to borrowing money from your retirement, there are long-term drawbacks that could be detrimental to your financial wellbeing come retirement. Whether you should draw from retirement to pay for home improvements is a personal decision, but carefully consider the long-term implications before making any decisions.
4 questions to ask yourself before using retirement for home improvements
That next project you’re eyeing, whether it be to improve your home’s curb appeal, increase the property value or finally create your dream kitchen, likely isn’t a cheap endeavor.
Regardless of whether you need to borrow a large chunk of change or are just filling in a financing gap, there are potential negative outcomes of using your tax-advantaged retirement account funds before you hit the penalty-free withdrawal period.
Here are four key questions that you can ask yourself to help determine if this is the right financial move for you and for your future-self.
1. What are the tax implications of dipping into my retirement savings early?
Any money initially withdrawn from your account for a 401(k) loan is considered tax-exempt, regardless of your age. However, the real danger comes in if you’re unable to make the payments in the future.
The U.S. government imposes a strict income tax policy when it comes to dipping into a tax-advantaged account — like a 401(k) or an IRA — before the required age of 59 ½.
If you fail to make the payments or default on the loan, you’ll receive a 10 percent penalty tax on the amount of taxable distributions if you’re below the required age.
Plus, according to the IRS, you’ll have to include any untaxed distribution in your gross income the year you take out the loan on withdrawals made prior to the required age.
2. Do I have the funds to repay the loan and make contributions to my retirement?
On top of missing out on potential compound growth, unless you’ve saved up double of what you’re projected to need come retirement, it’s likely that you’re going to need to play a bit of catch-up to get back into good standing.
With a 401(k) specifically, you’re allowed to borrow up to 50 percent of your savings. However, some plans prohibit you from making contributions until the entirety of your balance is paid down. What’s more, loan payments aren’t considered to be contributions and won’t add to your current balance.
Even if your plan does allow you to make payments and you can comfortably pay down the loan and increase your contributions, you’ll still have missed out on earnings through compound growth on the amount withdrawn.
Finally, consider how far you are away from your desired retirement and use a contributions calculator to determine how much you’ll need to put away to retire comfortably. If you’re inching closer to your 50s, withdrawing is likely not the best option for you, no matter how much you take out. You’ll pay more in taxes and have a much shorter period of time to replenish those lost savings.
3. If I were to leave or lose my job, can I repay the balance in the required amount of time?
Even if you aren’t planning to leave your job anytime soon, it’s important to consider all of the potential future scenarios. Given that the average 401(k) loan has a repayment period of five years, if there’s any doubt in your mind that you’ll be at the same company five years from now, then it’s best to look elsewhere for funding.
While it does depend on the company you work for, most plans will require you to pay back your loan by the due date of your federal income tax return. Some companies may offer a short window as a grace period, but that’s not a guarantee.
If you can’t repay your loan within the required time, then your remaining balance may be taken out of your existing 401(k). This is known as a “loan offset” and is also subject to being taxed as income and the 10 percent withdrawal penalty for those younger than 59 ½.
Those who can’t make the payments also have the option of contributing the loan amount to a separate IRA account and have until the tax deadline of the following year to contribute the entire loan amount.
4. Will the home improvements add value to my home?
It’s not guaranteed that every home renovation or improvement project will increase the property value of your home. Keep in mind that the return-on-investment (ROI) percentage on a renovation is different from the increased home value.
For example, you could end up spending more on a project — like replacing your carpets or replacing all of the windows and doors — than it would increase your home’s value. However, there are some improvements that are more likely to add value to your home than others. Here are a few examples:
- Making energy efficient improvements
- Remodeling your bathroom
- Enhancing the exterior of your home
- Converting your basement into a living space
- Renovating your kitchen
When it comes to determining if a renovation will add value, there are multiple factors at play. For one, the current real estate market trends in both the nation and in your area play a large role in what improvements will fare well and what will fall flat.
There are also extenuating factors to take into consideration, down to the preferences of the potential buyers, the neighborhood and area your home is located in, the quality of the job and the materials used.
Renovations that may not add value to your home
If you’re making changes that are outside of the general characteristics of your home or neighborhood, then they’re less likely to boost curb appeal. For example, painting your house an unusual, bright color in a neighborhood of colonial-style homes with muted color schemes isn’t likely to enthrall most buyers.
As a general rule of thumb, it’s not the best idea to consider a 401(k) loan to make lavish or unique changes that bump the value of your home up to higher than the average market value in your area. If you have any questions or reservations about whether using a 401(k) loan is best suited for your specific project, speak with a local realtor familiar with the market or consult a financial advisor.
Pros and cons of using a 401(k) loan to fund home improvements
While most experts and advisers would likely advise against using retirement funds of any kind for this purpose, there are a few advantages that make it appealing to some borrowers.
- Initial tax and fee exemptions
- No hard-credit check
- May have lower interest rates than other loans
- Reduces compound growth
- Loan repayment may cost more than your retirement contributions
- Significant risks involved if you can’t make the payments or lose your job
When to dip into retirement for renovations
If you need the repairs done urgently or immediately, have the financial cushion to replenish your accounts come retirement and have considered the following options, then dipping into retirement may be worth considering.
Home equity loans or HELOCs
Home equity loans and HELOCs (home equity lines of credit) dip into the equity you’ve built up in your home. Home equity loans are best for short-term, fixed projects while HELOCs function as a line of credit and are best for longer-term, more expensive renovations.
Home improvement loans
Home improvement loans are personal loans that are designed specifically to be used on home improvement projects and related expenses. However, due to the current rates right now, personal loans may be an expensive route to take if you have lower credit.
For homeowners who are unable to afford an additional monthly payment on top of the mortgage and are financing a smaller project, a cash out-refinance may be the best option. It essentially replaces your current mortgage with a new, larger loan. However, you’ll likely need excellent credit to qualify and it’s only a good idea if you can secure a lower interest rate on your mortgage than what you currently have.
0 percent APR credit card
Some credit cards offer interest-free introductory periods. Typically lasting between 12 and 24 months, these cards are only well suited for those financing a relatively small project that can be comfortably paid off within the 0 percent period. If not paid off within this time, the interest rates charged are typically sky-high, which will only push you further into debt.